The Financial Advocate: Fall 2022
Shocks to the System
The Speculation Leadup
It’s hard to believe that the difficult, volatile market conditions that we are currently experiencing began a full year ago. In November 2021, volatility began to tick up and specific market “fads” began to unravel. You may remember some of them … “meme” stocks, SPACs, every form of crypto, a seemingly endless stream of IPOs… Day traders dominated the retail investment market. Government stimulus checks went directly into online brokerage accounts which were then levered up with margin, and… “let the games begin!” Speculation was rampant.
Hindsight is 20/20. While there was above-average speculation in 2020 and 2021, we were entrenched in a period of economic expansion. The economy was very much in “recovery mode” from the pandemic. High-quality companies were seeing both revenue and profit growth. So, while some areas of the market looked frothy, other areas were reasonably valued. It is also important to remember that periods of above-average speculation can go on for lengthy periods of time. Do you remember the late 1990’s? For internal, actively managed portfolios, we began to gradually peel off risk in late 2021.
It wasn’t just the small retail investor that was in a giddy mood. One of the first acts of the new administration was to pass a $1.4 trillion stimulus plan, even though the economy’s recovery was underway. The Federal Reserve was keeping interest rates at 0% while pushing money into the bond markets on a monthly basis. (They did so until March of this year). Growth forecasts were robust, and we were repeatedly told that any inflationary threat was anticipated to be “transitory.” Unemployment was near record lows and companies from all industries could not find enough workers.
Well, as you know, a lot has happened since then. Earlier this year there were two significant and unanticipated shocks to the global economy. First, the depth and severity of the Ukraine war was not in anyone’s game plan for 2022 (including Putin’s). The second shock was the complete and rapid reversal of Federal Reserve policy.
Ukraine, Fossil Fuels, and Inflation
First Ukraine. The human, societal, and geopolitical impact is simply staggering. The impact of this war will be with us for the rest of our lives, arguably generations. For the purposes of this discussion, we are going to focus on the economic impact. A major percentage of the world’s fertilizers and food come from Ukraine. Significant manufacturing supply chains run through Ukraine. Defense budgets for major nations are on a steep incline due to the conflict. Russia is a major energy exporter; energy disruption in Europe is immense. (It has spillover effects across the global economy). European nations are scrambling for alternative supplies of energy and winter is quickly approaching. Thankfully, stockpiles of energy in Europe are nearly full heading into winter. These types of disruptions inevitably lead to rising costs – Inflation!
Like it or not, the world still runs on fossil fuels. We are of the belief that the United States does not have a coherent energy policy – and that it has not had one ever since the last energy crisis in the 1970’s. A well-articulated energy policy would suggest that it will take at least a couple decades for alternative energies to become mainstream enough to have a meaningful reduction on our reliance on fossil fuels. That is not to say that we should not be investing heavily in alternatives. However, we still need a functioning fossil fuel complex to keep things running today. Energy costs are reflected in everything we use and buy. The cost of transport, packaging, electricity, and heating are all influenced by the cost of energy. All these input costs remain elevated. (Read: inflation).
The Federal Reserve “Change Up”
The second major shock this year was the change in global monetary policy – specifically that of the Federal Reserve. As recently as March of this year (hard to believe) the Fed had target interest rates at zero and was pouring billions per month into the financial markets. (Specifically Treasury and mortgage-backed securities). We were repeatedly told that inflation was going to be transitory, the job market would come into balance, and everything would go back to normal. None of that happened.
Seemingly on a dime, the overly accommodative Fed noticed that goods inflation was running out of control, wage inflation had begun, and price spirals not seen since the late 1970’s were becoming a real threat. The money spigots were shut off and the march to higher rates began. Typically rate increases occur in 0.25% increments. Not in 2022! We have received four 0.75% rate hikes this year, one rate hike of 0.50%, and one rate hike of 0.25%. Futures markets suggest that we will receive another 0.50% rate hike come December. 30-year mortgage rates are already over 7%. Housing activity has stagnated. Prices could start coming down as well. (Despite the slowing of housing activity, home prices are still up north of 10% year over year).
This policy by the Fed will ultimately slow the economy, job growth, and corporate earnings. Recession seems like a very probable outcome. When investors perceive stagnant or falling earnings, stocks fall. Since an investor can now receive 4% on short-term Treasuries, they ask themselves, why take additional risk in the stock market? Granted, this thinking is somewhat short-sighted. Yet, it is a central theme dominating today’s equity markets.
The employment situation is much more difficult to predict. We are structurally short about two million workers in all types of industries. Where did they go? Covid sent some people home permanently, more parents now home-school their children, many Baby Boomers opted for early retirement, and sadly, some people died. So, the workforce is very tight and with little hope for improvement. These employment trends are inflationary and will likely be “sticky.”
Let’s do some straightforward math. Investment analysts like to put a “multiple” on corporate earnings to create target prices for everything from select companies to market indices. Given an investor’s level of optimism or pessimism, the multiple can change. Similarly, corporate earnings are variable. In a strong economy when business trends are favorable, earnings tend to rise. During periods of stagnation or recession, earnings historically fall.
For this illustration, let us agree that the S&P 500 currently has a price level of about 3800 and earns approximately $225 per share. That means that the market multiple is approximately 17 times earnings. ($225 X 17 = 3825). Now look at the second variable – the multiple. Why 17? This is where it gets dicey; a market multiple of 17 is not written in stone, it could be 12 or 15 or 20…. The main factors on the multiple for stocks are interest rates and the prospect of earning’s growth over time. If interest rates are high (or rising) multiples historically contract; the reverse is also true.
Let’s examine two scenarios:
(1) Interest rates rise and earnings fall to $200 per share. The multiple shrinks to 15. $200 X 15 = 3000. That represents a 20% contraction from current levels in the S&P 500.
(2) Rates fall and earnings rise to $240 per share. The market multiple increases to 20. $240 X20 = 4800. This scenario would show about a 25% S&P 500 increase.
You can see from this simple math why the range of analyst calls on the stock market is so wide. Consensus is difficult to find. Those who believe recession is inevitable naturally expect earnings to fall and rates to continue higher. This would lead to lower equity markets. Those who believe in a “soft landing” believe earnings will hold up, the Fed will pause rate hikes, and multiples can expand. This would lead to a rising market.
We believe that the Fed is nearing the end of this tightening cycle. We do not rule out a few more rate increases. But, we are closer to the end of this process than the beginning. Once concluded, we will see the full economic impact of these higher rates. If a recession ensues, it forms the base for the next recovery. Stocks move in anticipation of “what’s to come” and will likely move up before the actual recovery can be measured. So, what should strategy look like?
Focus should be on holding the highest quality investments. In actively managed, internal accounts, we are starting to accumulate longer duration and higher yielding bonds for income portfolios. And, it is a good time for prudent investors to go “bargain shopping” in the equity markets. (In actively managed, internal portfolios, we have accumulated select positions that we believe have been “oversold” and are at deep discounts). This is a time that investors should be adding capital to their investment portfolios. We, at VWM, are in a interesting business where people never want to buy when everything is on sale! Stick with quality and be patient. Remember Warren Buffet’s famous quote: “Be fearful when others are greedy, and greedy when others are fearful.”
Economist’s Corner by Roger Klein, PhD
The Federal Open Market Committee (FOMC) met in November and increased the target federal funds rate by 0.75% to 4.00%. The FOMC began increasing its target interest rate in March. The initial increase was just 0.25% and that was from a base of zero. Monetary policy impacts the economy with long and variable lags, so it would be reasonable for the Fed to reduce interest rate increases at subsequent meetings of the FOMC as they step back and assess how the rate increases have impacted the economy and inflation. Expectations are for a 0.50% increase in the target interest rate at the December meeting of the FOMC. That would put the target interest rate at 4.50% at year end. A 0.25% increase at the following FOMC meeting early next year would put the terminal target federal funds rate at 4.75%.
Thus far, the economy has continued to grow as the Fed has increased its target interest rate. After two small declines in Q1 and Q2, real GDP grew at a 2.40% rate in Q3. The Federal Reserve Bank of Atlanta estimates real GDP is growing at an annual rate of 4.00% in Q4. Will the Federal Reserve be able to bring down inflation and keep the economy growing? Thus far, the economy has withstood the interest rate increases while inflation has remained elevated. Inflation is public enemy number one and the Fed will keep its target interest higher for longer until inflation moves down to the 2.00% inflation target.
Managed Model Strategy
The Global Alpha portfolio has largely moved to a recessionary position (higher cash reserves married with defensive, low-beta equities). During the quarter, the portfolio realized profits in materials, energy, and fertilizers. Structurally, a growth portfolio is highly dependent on the level of interest rates and inflation. The higher rates go, the greater the discount for growth investments. The Fed has moved from accommodative to hawkish (a 180-degree turn) in relatively short order. The “transitory” inflation has become structural. Against this backdrop the “next-gen” investments of the future are not the place to be in the short term. Robotics, artificial intelligence, internet of things, 5G, gene editing, etc. will have to wait. Meanwhile, the accumulated high cash reserves will be used to add solid growth investments trading at large discounts. This process will take time. We are highly sensitive to current inflation reports and the continued Fed interest rate tightening. If markets continue to retreat, we may deploy “short” positions to help buffer the decline.
Global Balanced has a defensive posture at this time. Allocations to international positions have been trimmed as has exposure to higher-beta portions within the domestic equity markets. This year’s uptick in yields provided a buying opportunity for US Treasury bonds. We established a position in the Two-Year Treasury through a direct bond purchase while also purchasing an ETF that maintains Treasuries with durations seven to ten years out. It is not unreasonable for the portfolio to continue to “build out” its underweight fixed income component to neutral. We also trimmed an overweight position in commodities to neutral. Cash levels are currently above average as a short-term defensive holding that can be used opportunistically. Should the market uptrend continue, look for Global Balanced to further trim exposure to equities.
The Moderate Allocation portfolio took several tactical actions in the third quarter. We closed our long dollar position for a profit. We also took a small profitable short position against the S&P 500 to hedge downside risk. We recently increased our allocation to bonds, thereby reducing our underweight to fixed income. We also used the weakness in the market to increase our equity holdings. The economy looks to be withstanding the Federal Reserve’s interest rates increases to this point. Future actions in the portfolio will be highly dependent upon the fundamental backdrop as the economy reacts to the tightening of monetary policy.
This quarter’s financial planning topic is “year-end tax planning.” Every year, the portfolio and wealth management teams work together to reduce your tax exposure in internally managed, discretionary accounts. This process includes looking for offsets to capital gains. Additionally, it is important to be budgeting for contributions to tax-deferred savings accounts with contribution deadlines that correspond with your income tax filings. (Think IRAs, Roth IRAs, SIMPLEs, SEPs, etc.). If you had capital gains or extraordinary income events in 2022 outside of the accounts that your wealth manager can see, please be sure to let them know as we can look for opportunities to help reduce your tax bill come April. The sooner we are aware of these events, the better we can position you, your portfolio, and your overall financial plan.
VWM Firm Update
Beyond market volatility, it has been a busy period here at Ventura Wealth Management.
Many of our clients have had the opportunity to meet and work with Terry Sawyer. After seventeen years of greeting clients and helping with office administration, Terry has decided to retire. (This is Terry’s third or fourth attempt at “official” retirement (we lost count) – So, we will see how well it takes this time!) Her daily presence will be missed by the staff and clients alike. We hope you join us in wishing Terry well with many years of travel and time with her family ahead.
We would also like to announce two fantastic hires to the VWM team. Sue Pasqualone and Katie Kramli-Parker have both been hired as Client Service Associates. Sue has taken point on helping to manage quarterly review appointments and is aiding Mary Marciante with daily operations tasks. She has quickly become a valued member of the team. Katie will be taking point in reception, handling the phones, and working with the operations team to help ensure that we are delivering you exceptional service on an ongoing basis. We are looking forward to working with both of them. Welcome, Sue and Katie!
Lastly, we are very excited to be getting “back to normal.” The office has been fully open for regular business for a little over a year and a half at this point. While many of our reviews are taking place via Zoom or phone call, we are happy to have you visit in person for your quarterly review. We’d love to see you! Additionally, we are looking forward to hosting in-person client appreciation events starting again in 2023. For those of you that are local, we hope to see you there.
As always, we appreciate your continued support. If you have concerns about your portfolio, please do not hesitate to reach out to a member of the team. Enjoy the holiday season!
Nick Ventura, CFP® CPWA®
President / CEO