No Pain, No Gain
October 6, 2023
I recently spoke in a personal capacity (not as a representative of August Wealth) at the Macro Intelligence 2 Partners Global Macro Summit in Beaver Creek, CO. where I discussed my thoughts on approaching portfolio construction in a post Covid world. Regular readers of my monthly would find my presentation to have similarities to the recurring themes I discuss.
I am grateful to Julian and Gretchen Brigden for inviting me, and I was humbled to be asked to speak to so many unique and intelligent investors.
It afforded me the opportunity to see Colorado in the fall. As an avid skier, I have spent a good deal of time there in the winter, but the Aspen trees turning colors this time of year was breathtaking. It will not be soon forgotten.
August Wealth has many clients in Colorado, and I am particularly close with an 84-year-old gentleman (GW) from Aspen that was gracious enough to invite me mountain biking with him. You read that correctly: 84 and mountain biking! We have become close over the years, skiing in the winter together. Trying to keep up with someone his age on the slopes is an inspiration. He is a beautiful skier, and a kind individual. I mention this because he may be as good at mountain biking as he is at skiing. I, on the other hand, am a proficient skier and a novice mountain biker. So novice in fact, that as I was riding, I realized the full danger of the sport. Enough realization for me to say to myself: “this is fun, and it is beautiful out here, but I do not desire to do this again.”
Soon after whispering these words in my head, I went down a slight incline on a washed-out narrow track, my bike slid, and I became a projectile hurling 20 mph into the ground. I have never broken a bone before, but I knew straight away that’s what had happened. Two thoughts went through my head: 1) Ouch, this is not good! and 2) Why did I put myself in this position? That was stupid!
Luckily, with the help of GW and another friend, a makeshift sling was put on my arm, and we hiked the five miles off the mountain and into an urgent care facility for X-rays to confirm that the collarbone protruding out of my chest was indeed broken, and that I should probably have surgery before going back to Westport, CT!
Gratitude Brings Me Back to Reality: When I spoke to team member Christina George about my situation, she (gently) said something that struck me: “Joe, maybe this is God’s way of saying; slow down a bit.” I didn’t have much of a choice but to slow down, yet it was still good advice.
My wife makes fun of me when I say: “it is what it is”. I love that silly expression because it’s another way of saying: “accept your reality”.
My reality was this: I am here in beautiful Aspen, CO in pain with a broken shoulder, exhausted, and monitoring financial markets that are causing dropping portfolio values for August Wealth clients in the short run. Poor me!
However, that was only the negative part of my situation that I was focusing on! By slowing down and reflecting, I realized there was so much more to the situation:
I was resting in a lovely unused condo in Aspen given to us by generous friends.
My friends that worked in the medical community there got me into Aspen Hospital for immediate surgery, and I was treated remarkably well by the entire medical staff.
Some of the best orthopedic surgeons in the world operate in this area.
The surgery went well, and the surgeon told me I would be skiing in January!
Friends came by, called, and texted to check in on me.
My wife (as usual) took care of me like a saint.
I was able to slow down, nurse my shoulder, and merely focus on recovering. Wow I’m Lucky!
What are the lessons for life and markets? • Preparation:
For Life: Surround yourself with friends, family, and clients that you love. Care for them while you are able. They will care for you when you least expect to need it.
For markets: Put in the work. Anticipate the unexpected. Understand what you know, what you think you know, and what you don’t know.
• Accept your reality:
For Life: Pain is going to happen. Let it transform you. Realize more of your potential.
For markets: Pain is going to happen. Be able to adapt. Develop a more robust process.
• Suffering usually presents opportunity:
For Life: Moving through suffering allows you to feel love more deeply. It allows for personal growth.
For Markets: Pain in stocks, bonds, and other assets usually represent opportunity for allocating toward future growth.
For Life: It’s the secret sauce of life. Joy or pain, you can be grateful for the experience if you are appreciative of the gifts within and around you.
For Markets: Understanding and appreciating that people, companies and economies want to develop and grow. Go with it; stay invested.
Current Thoughts on the Market: • What do I know:
Interest rates have not been this high since before the financial crisis in 2008.
CPI Inflation for flexible goods and services is coming down dramatically, and inflation expectations* are lower than they were a decade ago.
The real, risk free rate of return (rate of return discounted for inflation) has risen.
Money market funds: Total level has risen from approximately $3 Trillion in 2018 to $6 Trillion in 2023. **
By many measures, small caps are historically cheap. The average Price/Earnings ratio of both the Russell 2000 and the S&P Small Cap 600 index is less than 13. This is according to Barron’s Oct 6, 2023 edition. ***
Student loans are going to start being repaid this fall.
Debt payments for autos and homes has increased dramatically in the last few years with the rise in interest rates.
Personal and corporate borrowing rates are much higher for new loans.
Much of this year’s equity market returns have been driven by a small number of Big Technology US companies (thanks JM).
• What do I think I know:
Recession may be more likely as consumers and businesses become constrained by higher interest rates. Delinquency rates on credit card loans are rising markedly.
Artificial intelligence is causing disruption on a scale and pace we have never seen before across a wide range of industries.
The market has recognized the growth of earnings from the hardware providers of chips propelling AI computing power by pushing up share prices of chip producers.
More expensive borrowing will likely constrain consumption and investment by:
Households and consumers.
Private Equity that relies on cheap borrowing.
Corporations and Real Estate holders that have a need to refinance.
Pricing power of corporations in many sectors of the economy seems to be eroding.
Covid Behavioral changes are likely to cause behavioral shifts that are difficult to forecast.
Anecdotal evidence we are picking up sees consumer demand dropping, which may mean economic data will start to weaken.
Many companies and indices may already be reflecting a recession risk. The Wilshire US Small Cap price index is not materially higher from where it was pre-Covid.
Investors are starting to realize purchasing long dated bonds at very low interest rates was a poor investment decision. (See chart below on real yields).
Investors may realize that private equity investments are not as great an opportunity as they once thought. The illiquidity risk and requirements of capital at expensive rates may continue to be a drag on future returns.
What could it mean?
Fixed income is now providing a decent real rate of return (above inflation) that provides certainty of cash flows. **
Is the cash or near cash (money markets and T-bills) investment earning approximately 5% at risk from rate cuts from the Fed in 2024? If The Federal Funds rate were to drop back toward 3%, this would likely require investors move toward longer duration assets. I believe there is reinvestment risk for investors sitting with high concentration in these investments.
Long duration assets may re-price higher well before any Fed interest rate cuts.
I believe the Fed will want to keep a positive real rate of interest across the yield curve even if they reduce rates. Cash flows may still be important relative to growth companies. Growing free cash flow is desirable when there is a reasonable cost of capital. This is a different environment compared to the negative real rates of interest we experienced in recent history (see chart of real 5-year yields above).
Users of AI will likely be beneficiaries moving forward. Small and medium sized business that can increase margins, scale business, and disrupt entrenched companies may be solid opportunities for investment. Many of the small and mid-sized companies in the USA are trading at historically reasonable valuations (see chart above on Wilshire US Small Cap index and Barron’s reference).
What Adjustments are Being Made? These are general changes to many of our portfolios, but it may or may not impact your individual portfolio. As always, please reach out with any questions.
We are increasing equity weightings and reducing cash levels. As usual, we look for companies that are producing and growing free cash flow. We believe valuations in small and mid-cap sectors are attractive relative to other parts of the market. We maintain our weightings in precious metals which we continue to believe will benefit from any major reduction in US interest rates. Geopolitical risks also continue to rise which should benefit demand for precious metals as well. We continue to like the energy sector. We increased our international equity weightings because we believe the dollar may start declining over the next year. We will also maintain diversification across the portfolios to reflect increased uncertainty and behavioral changes which we continue to believe will impact the markets going forward.
One final addition is Consumer Staples because we believe the sectors is being unduly punished by the new weight loss drugs being offered. The market is extrapolating (diet) behavioral changes rapidly, but we believe brands such as Procter & Gamble, Costco, PepsiCo, Walmart, Target, and others like them will adapt to changing consumer tastes where needed. The consumer staples sector offered by SPDR is nearly unchanged in price over a 3-year period (see chart below)i:
Joseph Cardello, Principal
August Wealth Advisors, LLC
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