Adjusting to the New World
June 16, 2022
What do I think? I am bullish on the US economy in the long term. I am bullish on quality companies that produce free cash flow, and I am much more relaxed about inflation compared to my concerns over a year ago. That said, the Federal Reserve is only now catching up to the mistakes made by keeping policy too loose and accommodating the Federal Government’s spending spree. This will continue to perpetuate a volatile environment. I believe that mental preparation and focus on the long term will be essential for investors.
Adjusting to the new world: Robert Armstrong wrote in this morning’s Financial Times the following:
Monetary policy tightening slows inflation by pulling demand down so that it no longer exceeds supply. How it does this is not subtle. It makes credit more expensive, so companies invest less and consumers spend less. It makes asset prices fall and asset markets less liquid, so companies and households become poorer and less inclined to spend. It makes people not get hired and it makes people get fired. It does this quite indiscriminately. It is not a scalpel, it is a sledgehammer. It smashes things.
Financial markets (prices of stocks and bonds) tend to adjust first and algorithmic trading may make these adjustments faster than ever before. I asked my friend a market news commentator what he calculated the expected range of the S+P 500 to be based on current levels of volatility in the market. His best estimate based on a current volatility measure of approximately 30% came out to be: Daily: 2.27% Weekly: 5% Monthly: 10.4%
In other words, moves of this size are expected to happen. The point being, although a 10% move higher might make us feel good and a 10% move lower will likely make us feel badly, I do not believe it provides new information.
How do you feel about the current market and your portfolio? It is different for everyone, but I suspect you feel some anxiety and stress. I understand this; I do not like watching my portfolio decline in the short run. Those who know me well understand and know that I am hard on myself. I have high expectations of myself, and of my ability to navigate markets. Despite reducing risk early and continuously in 2022, it was not enough, and it would never have been enough in hindsight. The only haven seems to have been a US dollar-based bank account earning close to zero percent interest. The question now is: What investments are a “safe” place for the next year, 5 years, 10 years? By “safe,” I mean investments that will protect your purchasing power over the long term.
Where do markets go now? It seems to me stock market prices are already reflecting an environment that predicts an economic slowdown. It appears to me that price inflation will wane considerably in the next year because of Fed tightening into a slowing economy where fiscal policy is also slowing. However, it takes time to adjust. The Federal Reserve is reacting to the mistakes the US Government and the Federal Reserve made in printing and spending too much money to offset the effect of Covid. We identified that as a likely mistake at the time, and we now posit that the Federal Reserve will hike too much at the wrong time. It is possible that what is already priced into the market for future hikes is too much, but only time will tell. We remain very patient despite the more attractive price levels in stocks and bonds. We continue to be defensive as outlined in last month’s commentary. As we have said previously, fixed income is starting to offer more attractive rates of return, but prices for bonds have declined further because of the Fed hiking rates by 75bp (bond prices decline as interest rates rise). The difficulty for our portfolios in the short term is that everything has become correlated. This tends to happen when the dollar appreciates, and portfolio risk is reduced aggressively. Over longer time horizons, we believe there will be differentiation across asset classes, within asset classes, and across geography. Ideally this diversification will produce higher risk adjusted returns. I am often asked where the market will go in the short term. Unfortunately, I cannot provide that guidance. I can only suggest that the pain and fear being felt today will produce the opportunities of tomorrow. I remain positive on the US Economy over time.
Planning, Process, and Faith: Planning: We spend a good deal of our time with the families we work with to determine your goals, risks, and psyche. We collaborate with you to invest an amount of capital that will not change your lifestyle when portfolio values decline, but it will hopefully protect your purchasing power by growing your wealth over the long term. Process: We deploy a rigorous process in our investment approach to your wealth, and we do this specifically for your needs. I have written about our process many times, but essentially, we look to increase equity risk when we believe we have an edge, decrease risk when uncertainty is high, and we always respect what we do not know. We diversify across asset classes, within asset classes, across geography and across time. How do we diversify across time? We assume volatility risk in the short run, in order to capture streams of cash flow and capital gains (assuming economic growth) in the long term.
Faith: We have faith in dynamic economic systems where capitalism is dominant. The expectation is that despite imperfect political systems, money will be allowed to flow to products and services that are in demand, and capital will flow to producers and innovators that best supply and anticipate future technological improvements in society. Economies have a propensity to grow over time, and we invest to participate in this economic growth.
Emotion and Investing: I was chatting to our summer intern recently about the difficult nature of markets, and what is so difficult about managing investments. It essentially comes down to emotion. The emotion that we all feel when we see our net worth decline. I suspect we get emotional about it because some part of us believes we could have used that money for some better purpose instead of investing and losing! We tend to make three mistakes here: Firstly, we seem to forget that we are investing on a 10+ year time horizon, and we focus on gains and losses over a 1-year period where we understand that gains and losses can be substantial. Secondly, we consume negative headlines in a negative state of mind, and it increases our anxiety. Thirdly, we tend to react to emotion. A large part of my role is to recognize the emotion, understand that it is only a feeling, recognize the impact this emotion is likely having on market pricing, and invest according to incoming evidence and probabilities.
One way of looking at your investment in the proper time frame: In my discussion with our intern, the following completely hypothetical illustration occurred to me: If we were to invest $1m dollars over a ten-year period, and the expected equity market return (based on history) is roughly 7% per year, perhaps we should view our initial investment in the first year as some range of values instead of an exact value of $1m. Let us assume the S+P will trade +/- 20% in any given one-year time frame. The range of our investment is between $800k and $1.2m in year one. If 7% is the average annual expected growth rate, in 10 years our investment would roughly double based on compounding returns. The expected future range value of our investment account would equal between $1.6M to $2.4M. I am illustrating this point only to try and find ways to reduce focus on returns in any given year. If we are investing for one year, and we require principal protection, we would do that with a fixed income instrument that matures in one year, pays a fixed percentage and returns your principal. If we are investing for growth, we must assume some degree of short-term volatility. If it is a mix of growth and income, it will be a balance of a fixed income portion to meet cash needs and a growth portion to grow in line with the economy.
We are grateful for the opportunity to serve you. We are here to help reduce anxiety around money and investing. We will do our best in these challenging markets to help you through. We do this by getting to know you personally. Getting to know your financial situation, your goals, your needs, and your risks. We discuss potential market declines and how you will feel about it before it happens, but when it happens, we realize it is hard. If your financial situation has changed, we want to know about it. As your advisor, we manage your portfolio based on you and your family’s risk in conjunction with our assessment of available opportunities for long term investment. The team and I are working diligently on your behalf. As always, thank you for your trust.
One of my favorite poems is by Mother Teresa. Someone sent it to me last week, and I am sharing it with you. You do not need to be religious or believe in God to appreciate it. I wish I had an opportunity to meet her, but I suspect it would have been a very short meeting. She was laser focused on her mission, and she did not waste time. This is a woman that just got on with what she was supposed to do. I have read that she questioned her faith often, but she somehow knew what she was supposed to do, and she never got distracted by others’ views of her, nor of her own feelings of doubt.
Mother Teresa's Anyway Poem
People are often unreasonable, illogical and self centered; Forgive them anyway.
If you are kind, people may accuse you of selfish, ulterior motives; Be kind anyway.
If you are successful, you will win some false friends and some true enemies; Succeed anyway.
If you are honest and frank, people may cheat you; Be honest and frank anyway.
What you spend years building, someone could destroy overnight; Build anyway.
If you find serenity and happiness, they may be jealous; Be happy anyway.
The good you do today, people will often forget tomorrow; Do good anyway.
Give the world the best you have, and it may never be enough; Give the world the best you've got anyway.
You see, in the final analysis, it is between you and your God; It was never between you and them anyway.
Joe Joseph Cardello, Principal August Wealth Advisors, LLC 51 Riverside Avenue, First Floor Westport, CT 06880 Direct (916) 461-9451 toll free (800) 985-9477
Investment advice offered through Stratos Wealth Advisors, LLC, a registered investment advisor; DBA August Wealth Advisors.
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S+P 500, 1
The Standard and Poor's 500, or simply the S&P 500, is a stock market index tracking the performance of 500 large companies listed on stock exchanges in the United States.
Where do markets go now?, 2 The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful. All indices are unmanaged and may not be invested into directly.