Wealth Management

Commentary:

U.S. equities, as measured by the S&P 500, were up +9.2%, the best month since November 2020. International Equities were up +5.0%[x]. Fixed income gained +2.4% as measured by the Bloomberg U.S. Aggregate Index.[xi] Gold fell -2.3%[xii] and crude oil lost -6.8%[xiii] as the U.S. Dollar Index gained +1.3%.[xiv]

On Wednesday, July 27, the Federal Open Market Committee raised the Federal Funds Rate (the interest rate at which depository institutions trade federal funds [balances held at Federal Reserve Banks] with each other overnight) by +0.75% to a range of 2.25% to 2.50%.[xv] During the press conference that followed the rate announcement, Federal Reserve Chair Jerome Powell said the Fed had already reached a “neutral” level of interest rates—one that neither boosts nor restricts economic activity. The S&P 500 gained +3.8% from the start of Powell’s press conference at 2:30p.m. July 27 through the close on July 29.[xvi] Many market observers attribute the post-FOMC meeting rally to Powell’s “neutral” comment. Has the Fed already done the heavy lifting? We think not and believe we are not alone in this thinking. Former Treasury Secretary Lawrence Summers said on Wall Street Week, “Jay Powell said things that, to be blunt, were analytically indefensible,” and “There is no conceivable way that a 2.5% interest rate, in an economy inflating like this, is anywhere near neutral.” Mohamed El-Erian, Chief Economic Adviser to Allianz SE and President of Queen’s College, said that “the zip code for neutral is above where we are now.”[xvii]

We have illustrated below just how far behind the curve the Fed currently is in its fight against inflation. In the previous seven tightening cycles, the Federal Reserve raised the Fed Funds Rate to a level higher than the inflation rate, as measured by CPI at that time, to bring prices down. As recently as April 2019, the effective Fed Funds Rate, the volume-weighted median rate, was 2.4% while CPI was up +2.0% year-over-year.[xviii]

July 2022 CPI was up +8.5% year-over-year, while the effective Fed Funds Rate is only 1.68%.[xix] We find it incredulous that with over four times the amount of inflation now versus in 2019 and with the effective Fed Funds Rate lower than it was, that the Fed is at “neutral”. The Fed may very well need to raise short-term interest rates a lot more to combat inflation. If it does, we believe stocks will have a sell off.

Having stock, interest rate, and other views that diverge from the collective wisdom of the market can be quite rewarding. In 1997, Apple Inc. launched the “Think Different” advertising campaign. The slogan was launched shortly after Steve Jobs returned to Apple to counter IBM’s slogan at the time, “Think”, a campaign for their ThinkPad.[xx] Apple’s market capitalization in 1997 was around $2.3 billion[xxi] and grew to $2.6 trillion at the end of July 2022.[xxii] IBM’s market cap in 1997 was around $86 billion[xxiii] and only grew to about $119 billion at the end of July 2022.[xxiv] “Think Different” has been very rewarding for Apple—not because of the slogan, but their strategies. Over that 25-year period, excluding dividends, an investment in Apple grew over +100,000% versus IBM’s +38% growth. Howard Marks, legendary investor and co-founder of Oaktree Capital Management, recently wrote a memo to investors titled, I Beg to Differ.[xxv] Marks’ memo highlighted, among many other things, how active investing and contrarian investing are some of the few ways that investors can achieve better returns than the market. In other words, think different.

Marks’ memo has fortified our investment committee’s approach to the entire investment decision-making process. Here we list nine items that we live by each day.

1. Most investors will have average returns. They may be good or bad, but they will be average.

2. If you are happy with average returns, buy index funds and allocate the same as the respective benchmark.

3. To be above average, one must stray from consensus behavior and do something different. One must over/underweight sectors, asset classes and markets. This is “active investing”.

4. Active investing carries both the risk of below average returns and the potential reward of above average returns.

5. When one departs from the herd of passive index investing, they need to use “second-level thinking” to dig deep to develop their investment strategy.

6. Second-level thinking, as Marks describes it is different, deep, convoluted and complex. It takes into account questions, such as:

a. What is the range of future outcomes?

b. What outcome do I think will occur?

c. What is the probability I’m right?

d. What does the consensus think?

e. How does my expectation differ from consensus?

7. Contrarian thinking can be beneficial at market extremes. To effectively act contrary to the masses one must know what the herd is doing, why it is doing it, why they are wrong and what your solution is.

8. Active investing and contrary thinking carry with it the risk of being wrong in hopes of reaping the reward of being right. An active investor seeks better returns than the herd at risk of falling ehind.

9. Howard Marks says it best, “Unconventional behavior is the only road to superior investment results, but it isn’t for everyone. In addition to superior skill, successful investing requires the ability to look wrong for a while and survive some mistakes.”

The CIG investment committee takes great pride in “Think Different”. We are currently over or underweight sectors, asset classes and markets in an attempt to limit risk while seeking to provide a return to meet our clients’ goals in their financial plans. The following are just a few items that we have a different opinion on than the conventional wisdom of many investors, a group that we call “the herd”.

1. The U.S. equity markets are still historically very overvalued—the herd is “buying the dip”.[xxvi]

2. Markets likely have not priced in an extended Russia/Ukraine conflict or the possibility of a China/Taiwan conflict, even though Blackrock rates the likelihood of both “high”.[xxvii]

3. The Fed raising rates at the fastest pace since 1981 and possible quantitative tightening as we head into a recession will be quite damaging to the economy and stock markets—the herd is already placing bets on the timing of the first interest rate cut.[xxviii]

4. Inflation will remain elevated for longer than most economists forecast—The herd believes inflation has peaked and will rapidly come down and the Fed will stop raising interest rates in the near term.[xxix]

Thinking differently is what allowed us to position our portfolios defensively in 2021 and as a result, year-to-date through July 31, our CIG Dynamic Growth Strategy composite has avoided approximately 54% of the growth benchmark’s losses and our CIG Dynamic Balanced Strategy composite has avoided approximately 61% of the balanced benchmark’s losses.[xxx]

Thinking differently does not mean being universally bearish or bullish about the future. Our thinking differently at CIG is about embedding imagination, like Steve Jobs did at Apple, in repeatable processes. In our case, we assess a wide range of scenarios and possible outcomes which are dependent on the path of critical, potentially life-transformative events to help clients succeed, regardless of how interesting the times are—now or at any point in the future.

We would welcome the opportunity to connect with you via voice or email to discuss how you think (differently) about life… about the markets and the value of active investment management.

Commentary:

June 2022 brought to a close the first half of the year and proved to be a difficult month for investors. The U.S. equities, as measured by the S&P 500, were down -8.25%.[ix] International Equities were down -9.28%[x] in spite of Chinese stocks gaining +6.66% [xi] as their economy reopened from COVID lockdowns. Fixed income offered no relief and lost -3.79% as measured by the Bloomberg U.S. Aggregate Index.[xii] Gold fell -2.09%[xiii] and crude oil lost -7.77%[xiv] as the U.S. Dollar Index gained +2.66%.[xv] The S&P 500 wrapped up the first half of 2022, down -20% year-to-date, marking its worst first half performance in 50 years. 10-year U.S. Treasury bonds had their worst first half performance since 1788, just before George Washington became our first president.[xvi]

Why has the first half of 2022 delivered such unfavorable returns across so many different asset classes? We believe the end of Quantitative Easing, “QE”, may be the root cause. During QE, the Federal Reserve (Fed) bought bonds in the open market in an attempt to increase the money supply and liquidity and lower borrowing costs. QE was first used in the U.S. in reaction to the Great Financial Crisis in 2007-2008. The first three rounds of QE ballooned the Fed’s balance sheet from $900 billion to $4.5 Trillion and ended in 2014.[xvii] During the fourth round of QE, the Fed, in response to the COVID-19 pandemic, almost doubled the balance sheet from 2014 levels to nearly $9 trillion.[xviii]

We discussed the Fed balance sheet a year ago in our June 2021 CIG Asset Management Review: Inflation and Fragility. In that review, we talked about how Federal Reserve asset purchases created a massive liquidity wave which dramatically increased the discomfort of holding cash with 0% yield and amplified the desirability of buying risky stocks that investors expect will offer higher returns. We cautioned that without continued Fed intervention, volatility would likely increase. Volatility has indeed increased—significantly. For the entirety of 2021, our proprietary CIG Volatility Signal was on for only 6 out of 252 trading days (2% of the days). Year-to-date through June 30, our Signal has been on for 76 out of 124 trading days (approximately 61% of the days). We have updated the chart from our June 2021 discussion below. The strong correlation between what appears to be an ever-increasing balance sheet and a stronger stock market, the S&P 500, continued until January 2022, when the Federal Reserve suddenly pivoted from a position of “inflation is transitory” to being more hawkish.

Data from: https://fred.stlouisfed.org and investing.com

On May 4, 2022, the Fed announced it would start reducing its nearly $9 trillion balance sheet on June 1 at the rate of $30 billion of treasury securities and $17.5 billion of mortgage-backed securities. This is so-called “quantitative tightening,” “QT”. Additionally, The Fed said it would increase the monthly reduction to $95 billion three months later.[xix] What progress has the U.S. Fed made in balance sheet reduction so far? The Fed only reduced its assets by $1 billion in June, which is nowhere close to the $47.5 billion that they originally talked about.[xx]

The U.S. Fed is not the only central bank considering shrinking their balance sheet and it’s no wonder, with central bank balance sheets being 5 times greater than they were before the 2008 Great Financial Crisis.[xxi] The Fed has just raised short-term interest rates from 0.25% to 1.75%.[xxii] Many economists expect the Fed to raise short-term rates an additional +0.75% at the July FOMC meeting. Suddenly, money markets and certificates of deposits offer a nominal yield. Morgan Stanley has estimated that in total, the world’s central banks may reduce their balance sheets by about $5 trillion by the end of 2023.

Could a 20% reduction in central banks’ balance sheets have a negative effect on the world’s stock markets? It is entirely possible. The Buffet Ratio, named after Warren Buffet, is a measure of total U.S. stock market capitalization to U.S. GDP. It has already fallen -22% from its all-time high of 202.5% in August 2021 to 157.5% as of June 12, 2022. The stock market, however, remains significantly overvalued, as we are simply back to the peak valuation of 157.5% in March 2000, which was right before the dot-com bubble burst.[xxiii]

Mere talk of reducing the Fed balance sheet in January sparked volatility and sent stocks into a bear market.

The Fed has gotten itself into a tough spot. Perhaps the economy will slow down so rapidly that inflation fades quickly, and the central bankers do not have to try and unload bonds. If the Fed maintains its almost $9 trillion balance sheet, or in fact increases it as a response to an unforeseen economic crisis, investors would likely be willing to take on more risk and send stocks higher. If employment remains strong and inflation remains historically high, they will be pressured to continue to raise interest rates and reduce liquidity by decreasing the balance sheet. June nonfarm payrolls were much stronger than expected, with 372,000 jobs created for the month versus the Dow Jones estimate of 250,000.[xxiv] June CPI showed inflation was up +9.1%, hotter than the +8.8% Dow Jones estimate[xxv] and the largest year-over-year increase since 1981.[xxvi]

Q2 2022 earnings season will bring the results of corporate efforts last quarter, as well as – more importantly – the outlook of those companies’ CEOs for what they see lies ahead for the rest of the year. The Federal Open Market Committee (FOMC) will meet on July 26-27 to determine how much to raise short-term interest rates. Higher rates mean less money for companies to spend on stock buybacks and real corporate expenditures and consumers to purchase goods and services.

Active management strategies are vital during periods when answers to important questions are unknown. Will the Fed do what they say they would and reduce their balance sheet? Could a 20% reduction in central banks’ balance sheets have a severely negative effect on the world’s stock markets? Will geopolitical stability be impacted? Will a “hard landing” and recession lead to no QT that brings the return of past trends or will various troubles create a future that has little similarity to history? Democratic decline, aging populations, fiscal deficits, polarizing geopolitics and deglobalization suggest uncharted territory ahead. How long this uncertainty lasts remains an open question and prudent investors must contemplate all scenarios.

Meanwhile, we “take arms against a sea of troubles”[xxvii] by continuing to take much less risk in our managed accounts versus traditional benchmarks. We will be patient and remain vigilant until some clarity is gained regarding inflation, interest rates and the direction of the economy. To QT or Not To QT: that is the question. Ah, “what [soft landing] dreams may come” from the World’s central bankers.

The Bard’s wisdom — “This above all: to thine own self be true”[xxviii] — prompts us to seek your questions, concerns and perspectives on the markets, the economy, and the value of careful active management, especially during uncertain times. We would welcome the opportunity to connect with you via voice or email.

In the 1999 movie The Matrix, Morpheus offers the protagonist Neo the choice between a red pill or blue pill. Morpheus says, “You take the blue pill…the story ends, you wake up in your bed and believe whatever you want to believe. You take the red pill…you stay in Wonderland, and I show you how deep the rabbit hole goes.”[x] Neo is offered a choice between continuing to live his life in contented ignorance or learning an unsettling, life-changing truth.

This type of choice was explored thousands of years earlier by Plato in his Allegory of the Cave. In it, a conversation between Plato’s brother Glaucon and Socrates describes a group of people who have lived their entire life chained in a cave facing a blank wall. These people watch shadows projected on the wall and believe the shadows are the only things that are real. What happens when one is freed from the cave to face reality; how would they cope; would they choose to return to the cave? The story goes on to assume a freed prisoner goes back to the cave to free the others so they too could learn the truth about the real world. Socrates and Glaucon conclude the other prisoners would likely kill anyone who tried to free them; that they would not want to leave the security and comfort of the world they perceived to be real.[xi]

It feels like markets have been living in the same contented ignorance as the aforementioned people in the cave and ignoring valuations. The Buffet Ratio, which is the total market capitalization of U.S. stocks divided by the Gross Domestic Product of the economy, hit a dizzying 202% on December 30, 2021. This was far more than the 143% seen back in March 2000 at the peak of the dot-com boom. While the recent sell-off in the markets has brought the Buffet Ratio back down to 170% as of April 30, 2022, it remains above the dot-com peak.[xii]

After a decade, it appears that some market participants seem to have begun stepping out of the cave to see reality. As of April 30, 2022, the S&P was down -14.3% from its all-time high hit on January 4, 2022, and the NASDAQ 100 was down -23.3% from its peak set back on November 22, 2021.[xiii] A bear market is defined as a -20% correction from the high. Surely with the NASDAQ 100 trading in bear market territory the worst is behind us, right? Not necessarily. In August 2020, we reminded investors in A Reminiscence of a Bubble Past[xiv] how the S&P 500 lost 50% and the NASDAQ lost 78% from the March 2000 peak to the October 2002 low.[xv]

As we discussed last October in What if the Bubble Bursts?[xvi], the market can trade lower for longer. It took just under 13 years for the NASDAQ 100 to recoup its losses after the dot-com bubble burst. Many investors are likely not comfortable with a 13-year time horizon where they simply just climb back to even. In April 2021, we asked the questions, Do you have enough time? Why is this time different?[xvii] and discussed how the average duration for a balanced portfolio was up to 43 years, 2.5 times longer than the historical average. The average duration corresponds to the time that it would take for investors to recoup their investment if they only received dividends and interest and never sold. The S&P 500 is +4% higher as of April 30, 2022 than it was on March 31, 2021, when the average duration was calculated.[xviii]

We are not alone in thinking that the market has become highly speculative. At the Berkshire Hathaway annual meeting on April 30th, Warren Buffet said U.S. markets have become “almost totally a casino,” and “overwhelmingly large companies in America, they became poker chips and people were buying and selling like three-day calls, two-day calls.”[xix]

Of course, markets – and the investors who participate in them – always operate across a broad range of risk with wise investment at one end and the “gambling” described above by Mr. Buffet at the other. The term speculation describes where one is on that range. Buying stocks with a “margin of safety” to protect the investment’s value in adverse conditions, like Mr. Buffett does, is considered less speculative, while uninformed or knee-jerk investments, such as short-term call option buying, are more speculative. Gambling involves the deliberate creation of new risks for the sake of diversion. Today, many investors see “investing” as a form of entertainment.[xx]

Assessing where the market is and where our clients’ portfolios should be along the range discussed above is among our most important focuses at CIG. Of course, we avoid gambling and attempt to be at the less speculative and more prudent side. Given our holistic approach and utilizing active management, The Ride[xxi] can be smoother, and clients may sleep better at night during periods like we are experiencing now.

Charles McKay, the author of Extraordinary Popular Delusions and the Madness of Crowds (1841), highlights that “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one” in speculative manias.[xxii] Recently, Bank of America’s Michael Hartnett discussed his Capitulation Indicators checklist suggesting that while the recovery process has begun, we have a fair way to go. For every $100 coming into the market during this cycle, only $3 has gone out. In past bear markets the average was $50 going out. Additionally, only 0.2% of industry-wide assets invested have moved out of the market versus 3% to 6% during prior market lows.[xxiii]

For those who would opt for the blue pill, we would welcome the opportunity to learn about where you think the market is and how your portfolio is positioned to weather the process of market capitulation ahead. We saw many bear market rallies during the dot-com bust, to only see the market grind lower for two more years before finally hitting rock-bottom. As of April 30th of this year, the Growth Benchmark is down -12% YTD, something not seen since the Great Financial Crisis.[xxiv]

Commentary:

Domestic equity returns for the month can best be looked at before and after the March 16th Federal Reserve (“FOMC”) meeting.

Pre-FOMC, March 1 through March 14 the S&P 500 was down -2.5%.[ix] As the Russia/Ukraine war intensified, crude oil hit a 13-year high of $130/barrel on March 7 with Europe and the U.S. considered banning all Russian oil imports.[x] On March 10, the February Consumer Price Index increased +0.8% m/m and +7.9% y/y, the highest rate since 1982.[xi] On March 15, the February Producer Price Index showed prices rising +10.0% y/y, tied with January 2022 for the biggest 12-month move since the current series began in 2011.[xii]

On March 16, the Federal Reserve raised interest rates by +0.25%, the first rate hike since 2018. In the press conference that followed the announcement, Federal Reserve Chairman Powell discussed in soothing tones[xiii] the timing of potential future rate hikes and that the Federal Reserve members are working on a plan to start to reduce the nearly $9 billion balance sheet.[xiv] “The Fed has got your back” seems to have become the dominant market narrative.

Post-FOMC, March 15 through March 31 the S&P 500 was up +8.6%.[xv] Despite reports of persistent inflation and an inversion in the yield curve, markets appeared to be encouraged that the next FOMC meeting would not take place until May 3-4. The war continued. On March 25, the University of Michigan Consumer Sentiment Index hit an 11-year low as consumers deal with the highest inflation in 40 years.[xvi] On March 29, the yield on the 5-year U.S. treasury surpassed the yield on the 10-year U.S. treasury, something that has not happened since 2006, before the Great Financial Crisis. In normal markets, as bond maturities lengthen in time, bond yields increase. An inversion in the yield curve historically has been one of the most reliable indicators of an impending recession.[xvii] Finally, on March 31, the Bureau of Economic Analysis released the February Personal Consumption Expenditures Price Index, the Fed’s favorite inflation gauge, showing a +6.4% annual increase in February, the steepest rise since February 1982.[xviii]

We continue to offer a differentiated view. Market history has taught us to be very careful during markets like the one described above. We scenario plan – we don’t forecast the market – meaning we are cognizant of the possibility of both continued upside speculation (like post-FOMC) and significant declines (like the 2000-2002 bear market). In significantly up markets like 2019, CIG captured mid to high teens for clients. When markets were more challenging in 2020, our clients were well-served by our risk-balanced strategy – an approach that strives for resilience to specific economic conditions. We currently hold positions in alternative assets, such as gold, a long/short fund, and a managed futures fund in client accounts which have increased in value year to date. Overall, we remain focused on striking the right aggressiveness versus defensiveness in client portfolios given the evolving uncertainty in the markets, economy, and geopolitics. Other market pundits appear to be more positive. On March 25, Jim Cramer on CNBC firmly stated, “I think the bear market is over!”[xix]

CIG attempts to manage the risk of the markets to try to limit losses. Risk management is key to how we think and execute – prudent investment management is prudent risk management. Given a holistic approach and utilizing active management, The Ride[xx] can be smoother, and clients may sleep better at night.

In today’s markets, how would you like to protect and then grow your nest egg to achieve your financial goals? We would welcome speaking with you to explore your needs and how you are tracking against your plan.

Commentary:

So far in 2022, inflation, interest rate fears and war in Europe have led equities lower as crude oil surged +27.27% to close at $95.72 a barrel[xvii] and the yield on the 10-year U.S. Treasury bond rose +0.33% to 1.84% on February 28.[xviii] Partially because of the horrible events in Ukraine, we have seen crude oil reach $130.50 and the 10-year U.S. Treasury bond as high as 2.13%, since then on an intraday basis. Amid these events, fixed Income did not provide a safe haven, as the Bloomberg U.S. Bond AGG Index lost -3.12% in the first two months. The S&P 500 suffered its worst January since 2009, during the depths of the Great Financial Crisis.[xix] The year is off to a difficult start. But what year hasn’t over the last few?

What does a bad first month suggest for the rest of the year? In 1972, Yale Hirsch, founder of the Stock Trader’s Almanac, introduced the “January Barometer”, which simply put says, as goes the S&P 500 in January, so goes the year. Our team is focused on illuminating potential blind spots as we attempt to manage the risks of the market in efforts to protect clients’ assets. There were many events in January that underscore the importance of managing those things that may fall outside of what is clearly visible.

On January 5, the minutes from the December 2022 FOMC meeting showed the Federal Reserve was becoming more hawkish than expected. A key section of the minutes stated, “Participants generally noted that, given their individual outlooks for the economy, the labor market, and inflation, it may become warranted to increase the federal funds rate sooner or at a faster pace than participants had earlier anticipated.”[xx]

Technology stocks are particularly sensitive to interest rates and the tech-heavy NASDAQ 100 Index reacted negatively to a potentially more hawkish Fed that same day, falling -3.1%, its largest daily loss since March 2021.[xxi]

We have witnessed many investor portfolios outside of CIG that are overweight large cap information technology stocks versus a typical growth benchmark. At CIG, we have significantly limited our exposure in what we believe is an expensive sector, to approximately 55% of the benchmark allocation in our managed accounts. To those who may read this who are not currently CIG clients, we would ask, “Do you know how much risk you are taking in technology currently?”

Many investors have also chased yield in a low interest rate environment and as a result, the duration of their fixed income portfolios may have increased. These portfolios tend to have more bonds that have maturities in the 10- to 20-year range. When interest rates rise, longer duration fixed income tends to fall more than shorter duration. Corporate bonds many times also lose value as higher rates can potentially lead to more defaults.

At CIG, we have limited the duration in the fixed income portion of our portfolios to approximately 90% of the Bloomberg U.S. Agg Bond Index. We have also limited our exposure to corporate bonds to about 2% of our fixed income exposure. The benchmark currently has 24% in corporate bonds that the Federal Reserve will no longer be buying once they stop expanding the balance sheet. Do you know how much risk you are taking in the fixed income portion of your portfolio?

In Part 2 of this Market Review, we consider additional potential risks given February’s events and explore further Yale Hirsch’s January Barometer. If you would like to learn more, please click here to e-mail Brian Lasher.

Part of our mission is well-informed investors. For those who may not currently be CIG clients, we believe you would find benefit in assessing what risks exist in your portfolio – such a conversation has no downside for you. A “second opinion”, if you will, seeking nothing more than to help increase your knowledge. Please click here to schedule a strategic review with CIG Asset Management.