Author: CIG Capital Advisors

Summary:

   * The Federal Reserve struck a more hawkish tone mid-month

   * U.S. stocks rebound after a dip

   * Markets appear increasingly fragile

Commentary:

Markets were stunned on June 16th as the Federal Reserve struck a more hawkish tone. Federal Reserve committee member’s projections now pointed to two interest-rate hikes in 2023 versus none before. The U.S. dollar jumped higher on the news, while many commodities reversed course from the prior month as inflation-focused investments suffered. Although the S&P 500 Index initially fell -1.6%, it fully recovered within days to end the month of June up +2.3%.[i] Overseas stock markets lost money during the same period with the MSCI EAFE net down -1.3% and the MSCI Emerging Markets losing -0.1% given U.S. dollar strength.[ii]

During the month, we reflected on the increasing criticism of the Federal Reserve by market commentators like Mohamed El-Erian, president of Queens’ College, Cambridge University, and adviser to Allianz. He believes the Federal Reserve is ignoring so-called transitory inflation at its own peril. In a June 30 Financial Times op-ed[iii], he referenced a Bank of America survey that suggests the markets are currently driven by a consensus around “durable high global growth, transitory inflation, and ever-friendly central banks.”[iv] El-Erian argues that possibility of unanticipated non-transitory inflation could upset this happy market consensus leading to significant economic and financial damage.

El-Erian has been very right in the past in our opinion. In a CNBC interview on February 3, 2020, he warned about the risks of the newly discovered COVID-19 virus. “It is big. It’s going to paralyze China. It’s going to cascade throughout the global economy. We should pay more attention to this. And we should try and resist our inclination to buy the dip”, said El-Erian.[v] The S&P 500 reached its then all-time high two weeks after that interview and then fell -35% until it reached the March 23, 2020 low.[vi]

More recently, on February 16, 2021, El-Erian warned in a CNN interview, “Investors are chasing what someone labeled the ‘rational bubble’. While they are fully aware asset prices are high, they expect prices could go even higher thanks to massive central bank liquidity and prospects of fiscal injections. Basically, investors feel confident riding what is a massive historical liquidity wave.”[vii] So far, investors have not heeded El-Erian’s warning. Indeed, as of July 9, 2021, the S&P 500 has rallied +11% from the CNN interview.[viii] The massive historical liquidity wave that El-Erian warned about in February 2021 continues to grow. Federal Reserve asset purchases shown in the green shaded area in the chart below has dramatically increased the discomfort of holding cash with 0% yield and amplified the desirability of buying risky stocks which investors expect offer higher returns.

data from https://fred.stlouisfed.org and finance.yahoo.com 

Constant intervention by the Federal Reserve and other central banks since 2009 have led to an environment of self-reinforcing speculation and a rising S&P 500 index shown in the black line. Reckless fiscal policy since 2017 has only augmented the atmosphere. In our opinion, entire investment strategies have now been built around the perceived certainty of Federal Reserve and central bank support. Retail traders’ share of stock market volume has surged since the lockdowns, and the number of individuals opening brokerage accounts is at a record pace in 2021[ix]. We believe that most bubbles end when the last marginal investor is fully invested. 

The belief that central bank liquidity has the capacity to support elevated markets indefinitely creates a reflexive response by the market as more and more investors jump on the bandwagon. Thus, the market becomes increasingly fragile. Consequently, a more aggressive Federal Reserve intervention is required with each market downturn which one can see in the chart above. El-Erian’s op-ed hints at the dynamics of certainty and fragility. Now markets move downward based on the Fed pretending to inch a teensy bit toward maybe raising rates over 18 to 30 months from now[x].

No matter what real world inflation we might be experiencing currently, debating the transitory nature of inflation is likely to continue to produce periodic setbacks for inflation-focused investments. Inflation expectations are changing, and it will take time for the debate to be settled in some fashion. Until these expectations are cemented in an alternative vision of the world by investors, market commentators and powerful institutions, we might expect the market to move in short order from calm to quite volatile.

For CIG’s clients, we will continue to take a risk balanced approach to this historically expensive market in these uncertain and fragile times. Risk balancing means moderating portfolios’ exposure to the consensus views of other investors as well as using hedging strategies like owning publicly traded hedge funds, gold, and volatility strategies. 

Understanding and paying attention to this environment is important to achieving your financial planning goals.

Summary:

   * S&P 500 Index posted its fourth consecutive month of gains

   * Active portfolio management beat the index

   * 2Q 2021 portfolio rebalancing activity

The S&P 500 Index[i] posted its fourth consecutive month of gains, up +0.7% in May. International markets performed better than the U.S. with the MSCI EAFE net up +2.9% and the MSCI Emerging Markets gaining +2.1% given continued U.S. dollar weakness[ii]. The Bloomberg Commodity Index[iii] returned +2.7% led by Gold, +7.7% and Crude Oil, +4.3%.[iv] Year-to-date, The Bloomberg Commodity Index has increased 18.9%.

As we talked about in our 2021 Outlook, since the 2008-2009 Great Financial Crisis, many passive index investors have been conditioned to buy short-term market pullbacks and have been rewarded as markets have continued to move to all-time highs. In our view, stocks, especially in the United States, continue to be expensive from a valuation standpoint. The Buffet Indicator, the ratio of the total market capitalization of U.S. equities to Gross Domestic Product, was 199.3% at the end of May. As we have discussed previously, to put this in perspective, at the peak of the dot-com bubble in March 2000, this ratio reached 142.9%.[v]

The month of May saw a return to active portfolio management. According to Bank of America U.S. Equity Strategist Ohsung Kwon, 70% of active managers beat the Russell 1000 Index in May, making it the best May in 30 years.[vi] We continue to believe that active management will benefit clients as we continue through uncharted economic and market territory, as we have discussed in our recent CIG Asset Management Reviews “Sir Isaac, Groucho, and the Gods” and “Do you have enough time? Why is this time different?“ 

Many large cap technology names such as Apple (-6.6% return) and Amazon (-7% return)[vii] were down for the month. The weighting of these two names, Apple 5.7% and Amazon 4.0%, dominate the S&P 500 index.[viii] Last month, Apple and Amazon were a large drag on performance of the S&P 500. Given lawsuits and other company-specific issues, we should not discount the possibility that further losses in these two companies could continue to negatively impact the S&P 500.

Generally, May featured several ups and downs in the U.S. stock market. In our opinion, broad market optimism was tempered by inflation concerns. In our minds, the recently released May Consumer Price Index[ix] confirms rising inflation. But as we recently explained in MarketWatch, lesser-heralded indicators like the Producer Price Index are flashing even more urgent warning signs that impending price increases may be still higher, and are more deeply embedded in the economy than the CPI would suggest. We may experience more volatile months like May, as market participants continue to debate whether inflation is transitory or not and how the Federal Reserve will react.

Given our views, we have continued to add to investments which may outperform if inflation is not transitory. We are in the process of rebalancing CIG managed client portfolios. We are decreasing our exposure to technology, adding an actively managed emerging market fund, adding an industrial holding that is focused on aerospace and defense, adding to our energy pipeline holding, reallocating a portion of our gold holdings into an actively managed mining fund and adding a volatility position that may benefit if market volatility perks up.

We continue to take a risk balanced approach to this historically expensive market in these uncertain times. We are not sitting still.

Summary:

   * S&P 500 Index posted its third consecutive month of gains

   * Financial market history books might offer lessons

   * Understanding human behavior may be the most important requirement right now

• Commentary:

• April featured a macro environment that tilted positive. The market reacted favorably to i) the Federal Reserve continuing to increase its balance sheet (greater than $1.2t over the last year), ii) a rebound in U.S. durable-goods orders, and iii) a record 21.1% increase in U.S. household income in March[i].

  We noted that the service PMI index of prices increased to 61% in April (manufacturing PMI also continues to suggest a greater inflation risk) and the COVID resurgence pushed the Eurozone into a double-dip recession[ii]. These potential risks seemed far from investor’s minds.

  Accordingly, the S&P 500 Index[iii] posted its third consecutive month of gains, up 5.3% in April. International markets did quite well with the MSCI EAFE net up 2.7% and the MSCI Emerging Markets gaining 2.4% given U.S. dollar weakness[iv]. U.S. Treasury Bonds had a good month after a significant selloff in March while the Bloomberg Barclays High Yield Bond index[v] returned 1.1%. Higher inflation expectations were supported by an 8.3% increase in the Bloomberg Commodity Index[vi] and a 7.4% increase in crude oil[vii] during the month.

  Recently, we have been reflecting on what the end game for financial markets might look like after reading noted economist Mohamed El-Erian’s May 3^rd opinion piece in the Financial Times entitled “Fed framework holds central bank hostage[viii].” We have been digging out our financial market history books to examine previous bubbles and manias and inflationary episodes to see what lessons they might offer for our immediate future and beyond. Of course, we cannot divine the timing of any eventual market shift. We recall Sir Isaac Newton’s famous quote in 1720 after initially making money in the South Sea Bubble, re-entering the scam, and then losing multiples more of his profit: “I can calculate the motions of the heavenly bodies, but not the madness of people[ix].”

  We have often mentioned in these updates how today reminds us of the Internet Bubble of 2000 and what we read from past bubbles echoes our experience then and what we are seeing today. What is a bubble? Nobel Laureate Franco Modigliani offered an insightful definition: “The expectation of growth produces growth, which confirms the expectation; people will buy it because it went up. But once you are convinced that it is not growing anymore, nobody wants to hold a stock because it is overvalued. Everybody wants to get out and it collapses, beyond the fundamentals[x].”

  Last year’s unprecedented market recovery which we talked about in the March Blog, this year’s GameStop democratization of the markets and cryptocurrencies’ ascendence, all seem familiar. In Charles Mackay’s “Extraordinary Popular Delusions and the Madness of Crowds”, first published in 1841, he recounts, “Many individuals suddenly became rich. A golden bait hung temptingly out before the people, and, one after the other, they rushed to the tulip marts, like flies around a honey-pot. Everyone imagined that the passion for tulips would last forever, and that the wealthy from every part of the world would send to Holland, and pay whatever prices were asked for them. The riches of Europe would be concentrated on the shores of the Zuyder Zee, and poverty banished from the favoured clime of Holland. Nobles, citizens, farmers, mechanics, seamen, footmen, maidservants, even chimney sweeps and old clotheswomen, dabbled in tulips. People of all grades converted their property into cash and invested it in flowers.[xi]”

  Like the recently announced second NBA-star-sponsored Shaq SPAC[xii], the 1920s stock market attracted the celebrities and “social media influencers” of that age including Groucho Marx, who borrowed over a quarter of a million dollars to play the stock market. He wrote in his memoirs, during that bull market there was no need to employ a financial advisor, “You could close your eyes, stick your finger any place on the big board and the stock you bought would start rising[xiii].” Marx along with Irving Berlin and Eddie Cantor of Ziegfield Follies fame speculated heavily and eventually lost fortunes[xiv]. (We will see how Elon Musk does with his cryptocurrency holdings.)

  Understanding human behavior may be the most important requirement right now and we have also looked to classic literature to understand the narratives that we tell ourselves at this point in the market cycle. It is easy to take these narratives and what you are being told by CNBC into your heart and act against your best interest. We reflect on the narrative, known as Nihonjinron, that the Japanese told themselves during their bubble of the 1980s – that Japan is unique and better[xv]. But such hubris is often a precursor to bubbles.

  Shakespeare’s observation about fortune seems truer that “she is turning and inconstant . . . the poet makes a most excellent description of it.[xvi] Exceptionalism is usually fleeting. To that end, we offer Rudyard Kipling’s poem, “The Gods of the Copybook Headings[xvii]” written post the 1918 pandemic and just prior to the 1920s bubble discussing the constancy of the human condition. The last two stanzas are chilling in reflecting on today’s market. We continue to pursue a risk balanced approach to the market – not fight the Federal Reserve or run for the hills; be in the game – it could last a long time; and maintain the appropriate emotional distance. We endeavor to not be the “bandaged finger [that] goes wabbling back to the Fire.”

Summary:

   * Re-openings and even MOAR stimulus

   * We may have to wait a long time

   * A not so typical market recovery 

• Commentary:
• In March 2021, equity markets continued to rally as Texas eased all business restrictions and lifted its mask mandate and the $1.9 trillion COVID-19 relief bill was passed by Congress and signed by President Biden, sending $1,400 payments directly to many Americans.  Almost immediately after the bill signing,  the Biden administration turned its attention to a $2 trillion infrastructure bill.  Federal Reserve Chairman Powell reassured investors after the March FOMC meeting that the Fed is not planning on raising interest rates until 2022-2023 at the earliest.  March went out with a bang, with the collapse of over leveraged hedge fund Archegos Capital which lost $20 billion in two days.[i]
•  For the month, the S&P 500 Index was up +4.4%[ii] while the international stocks in developed economies, as measured by the MSCI EAFE Index Net, gained +1.8%[iii]. Emerging Market stocks (MSCI EM) were down -1.7%[iv].  Value stocks, measured by the Russell 1000 Value Index, added +5.9% and the Russell 1000 Growth Index, a measure of growth stocks, was up +1.7%[v]. Small-cap stocks, represented by the Russell 2000 Index were up +1.0%[vi]. Crude oil fell -3.8% for the month and Gold fell -0.8% [vii].
• Recently, we found a 2017 study by S&P Global[viii] that is informative for the current environment. As you may know, every investment is a claim on future cash flows that can be anticipated to be delivered to the investor over time. While the concept of “duration” is most used for bonds, it’s actually applicable to any investment and can be defined in two ways: i) the weighted average number of years it takes for the investment to deliver its payments[ix] and ii) the percentage change in the investment’s value in response to a change in the underlying gross rate of return. The second definition allows us, with some math, to convert a stock’s dividend yield to duration.
• As shown in the chart below by S&P Global, the duration for equities (i.e., the S&P 500 Index) over the past 149 years ending September 2016 has ranged from 13 to 63 years.