All in All it's Just Another Brick in the Pond

*For context FYI, due to an extended approval process this piece was written in its entirety prior to the Silicon Valley Bank situation*

This winter was the first in two years where children found each other face to face and completely without masks. If you, your kids, your co-workers, or your friends have any exposure to school age kids, you have some level of understanding of how this winter went.

Within my household of four resides a second grader and an 18-month-old. Every day they go to school and daycare, a world that still hasn’t learned about personal space and a snake pit-lair of snotty noses, respectively. The result? At least 1 of us has been ill on some level since Halloween. I personally had some level of sinus sickness from Christmas through the end of January (my brain feeling like it was being stabbed every time I sniffled didn’t help how long it took to finish this piece).

As a result, throughout the country, record levels of parents have had to stay home to care for their children this winter. The combination of RSV, Flu, and COVID (while throwing in a stomach bug every now and again for good measure) proved a toxic mix as the weather grew colder. Doctors have described the phenomenon as an “exposure debt.” This bill was now due. Sickness in kids is natural and inevitable. But no matter what you call it, this winter’s massive volume in child illness and the effects they had on working parents and the economy is a direct result of COVID and its lock downs. In all aspects it’s been like a proverbial brick that was thrown into the pond of our everyday lives; its ripples were far reaching. Will we get through this winter? Of course. On one level or another these ripples were unavoidable. The best we can do is try to power through the current situation. Ultimately, I know I’m able to mentally tolerate these ripples as a parent because of what I understand about the very nature of bricks that are thrown into ponds. Over time, as these ripples extend from their COVID epicenter, they become smaller and smaller. Smaller until the surface of that proverbial pond will smooth out once again.

This is the same in the financial markets. In the past year plus, the rise of inflation due to the combination of economic stimulus plans, the potent Omicron variant, the buckling of supply chains, war and geopolitics, uneven policies on virus containment though out the country and world led to uneven and disorderly re-openings (just to name a few issues). The Federal Reserve is battling all of it with steep interest rate hikes which have created massive ripples in the financial markets, throwing everything into chaos. Last year, traditional risk relationships between asset classes were largely worthless and pockets of strength proved fleeting in extremely short order as the reality of what was actually happening in the economy seemed to change on a dime. As I pointed out in my last piece, It was a year of disorder. It was a year that was more like brick after brick after brick being thrown into the pond, creating ripples that crashed against each other and spread out in ways that hadn’t been seen in the pond ever before.

With that I promised some final stats once the year ended. Although I could flood you with more than you ever wanted to know, here are the ones that fascinate me the most:

? The worst year for combined return of US stock and bond investors since 1871 (-17%) – Source: Robert Shiller, Yale University economics department

? 62 – The number of days the S&P 500 finished the trading day down more than 1%. This is the 3rd most since 1940 (2008; 1974) – source: compound.com

? 7 – The number of months the S&P 500 dropped more than 2.5%. Tied for most on record since 1920 with 1931 and 1937. – Source: Macrocompass.com

? Long Term US government bonds staged their biggest drop since 1788 – Source: Deutsche Bank

And last but not least:

? Bank of America Global research recreated the World Bond index’s annualized returns going back to year 1701 (GDP weighted). 2022 was the 4th worst year for global bonds in 323 years. Only beating out the South Sea Co. Bubble bursting in 1720, the end of the American Civil war in 1865, and the end of World War 1 and (ironically) the Spanish flu pandemic in 1920.

Although I believe the general public doesn’t truly comprehend how abnormal last year was, I don’t share these statistics for mere shock value. I share it because this level of disruption and volatility doesn’t happen in a vacuum. We can’t just expect to go back to the way things were in the economy and the financial markets. Not only due to the size of the COVID brick(s); but because 2022’s ripples were exacerbated beyond what should have been their natural progression from the epicenter to begin with. If the analogy holds, we would still have to expect that these ripples need more time to sort themselves out in order to return to a smooth(er) pond surface once and for all (if there ever was one). Uncertainty is what creates value in stock prices overall so riding these ripples seems logical in general. But we also have to consider that although the surface will eventually smooth, the pond itself may be changed forever.

True to form, we’ve already started to see a ripple effect move in the opposite direction in the past month and a half. Some of the hardest hit stocks and industries from last year have slingshot back and become big winners in very short order. “Risk on” became the mantra again overnight throughout January, and then reversing on itself in February. Regardless, with each passing day there is more and more talk of the idea that the October lows in the market were just that, and a new bull market is beginning.

Before I dive into that possibility, let’s back up to what I promised I’d share last piece in a few examples of what I see longer term:

 In technical analysis there is a saying that says, “When in doubt, zoom out.” The idea being, the short term can be extremely chaotic and it’s easier to see a general pattern forming in technical charts the longer you look back in history. I spent a lot of 2022 “zooming out” in many respects, both technical and otherwise. In a year that separated itself from norms I was looking for data and movements that could be explained into larger patterns. The reason being, with a little deductive reasoning, we could look for longer term tailwinds that could be forming. When applied correctly, tailwinds can provide extra confidence in investing during periods of uncertainty. As these ripples work themselves out, understanding what the pond will eventually look like has been my concentration. Here are a few themes I believe will persist (in overly simplified terms):

It’s all about the Benjamins

The value of the US dollar to be more precise. This past year it’s arguable that nothing has been more important to the movement of stocks than the value of the dollar. Dollar is strong? Bad for risk assets. Dollar is weak? Good for risk assets.

The dollar is the world’s dominant currency as the US is the world’s dominant economy. A currency declines in value if there is an oversupply of it. Due to an explosion of US debt in both terms of sheer quantity and now cost to service it (bond interest rates have skyrocketed as the Federal Reserve fights inflation), in purely mathematical terms, the only way we can pay our debt is through printing more money long term. By definition, this leads to higher inflation and decline in the value of the dollar. Real assets and stocks are best in an inflationary environment long term. Zooming out on a chart of the dollar, we have a logical high point (potentially forever if we cite our friend from past writing, Dalio) in the dollar index target to work off.

Conclusion: Short term, inflationary pressures make the Fed’s job harder and will keep the market on its toes as it creates the environment for a stronger dollar, and subsequently the possibility of extreme volatility. But the long-term tailwind from a declining dollar, which to me the evidence is overwhelming, is good for stocks and real assets; even if it’s not good for the country we call home overall.

Ding dong, FAANG is dead

FAANG (Facebook, Apple, Amazon, Netflix, Google) and Mega Tech has dominated portfolio returns for the past decade/ post Financial Crisis since 2009. Their gains have been nothing short of massive. Although there are innovation and profitability reasons behind a lot of these gains, Federal reserve liquidity/ cheap money and a low interest rate environment made significant contributions as well. Not only is cheap money no more; these companies can arguably be considered mature from a growth standpoint. Markets move in cycles and nothing leads forever, let alone for a decade. Everybody owns them and the exit door is small to get out should things go sour.

Conclusion: These companies aren’t going anywhere and will continue to be popular targets. But the long-term tailwind is most likely over. Ask the dip buyers of market cap leader Cisco at the end of the dot com bust or the buyers of Citigroup at the end of the financial crisis how they fared once the respective pond settled, and the financial world had moved on. Risk vs return = I’ll be avoiding Mega Tech as much as possible. This will eventually become a major realization in investor sentiment and the shift could take a while to play out. Sometimes just avoiding these types of pitfalls is a long-term portfolio win in itself. Innovation will continue, so tech investing is still a must (a later piece I have in mind on this), but the concentration will be shifted going forward.

We’re going Worldwide

 I’ll write this one out like an equation:

International stocks perpetual underperformance since 2009 + American Mega Cap Tech/ stock in general perpetual overperformance since 2009 + tailwind of declining dollar + higher cost of capital (interest rates) leans capital towards better value oriented investments + vast under ownership by most of this country’s investor class + international/domestic stock performance leadership tends to change over decades, not year by year = Potential mega trend in the making.

Money always flows to where it’s treated best. But that change in the money flows of investor behavior can be like steering a tanker. It takes a while to change direction before the momentum can really build and move full steam ahead. I believe we have enough evidence to comfortably move (shifting world order and otherwise) before the tanker fully turns. At the very least from a risk versus reward standpoint.

Headwinds/ Tailwinds….

Regardless of all of this, we still need to be cognizant that the world has changed forever. For more specific reasons I’ll most definitely bore you about in the future, we need to face the reality of what the pond will be once these ripples subside. From a very basic standpoint that means we can’t approach investing the same way we did “pre-bricks.” This includes some of what was mentioned before, but also goes deeper on strategies, trends in society and demographics, and dealing with risk. I have no doubt investors will continue to invest like they did pre-pandemic. On a very basic level I believe this approach will ultimately prove futile. Everybody has different time horizons, risk tolerances, and investment preferences. But ultimately my objective for all my clients going forward is to not allow you to fall into the same futility trap of others.

Conclusion…. that will partially leave you hanging….

Outside of my sinuses and sick children controlling my life for the winter, the delay in this piece comes from having an overwhelming amount of information I want to share and discuss. Trying to condense it while doing it justice proved incredibly frustrating, but I tried. I also failed. After much effort it makes most sense to push off some content until next time. But I will conclude with this (while also circling back to the short -term question of whether the market has bottomed mentioned earlier):

I am already transitioning portfolios towards the tailwinds of what I believe the pond will look like once the multiple brick throwing stops and the ripples begin to subside (they never completely stop) and we can finally move forward with confidence over the long term. But I am not moving full force on this yet. In the shorter term, when it comes to data and evidence on whether the market has bottomed, I would rate at roughly 50% it has, 50% it hasn’t. Both cases are as compelling as they are complicated. But If I had to firmly chose one or the other right now? I would say it has not bottomed. It’s just the risk of a reckoning keeps being pushed out further on the timeline. I would argue this is what the Fed prefers from an economic perspective. But in the same breath, I will acknowledge it is torturous as investors (and advisors) as we all want closure almost as much as we want optimism.

We have to rely on data and evidence above all because that is how responsible, serious people who live in reality behave. And as I always remind you, I don’t have the luxury of living anywhere else but in reality. But data aside the risk that the market hasn’t bottomed yet exists because of the inherent nature of bricks thrown into ponds and the ripples they create.

When you look back at the statistics which I shared with you about 2022, we don’t just see ripples. We see massive macro-economic waves from ripples crashing into other. Changes that only come about in terms measured in centuries or generations. Changes that have led to 7% mortgages, double digit car loans, and 20% plus credit card interest in record time. As much as I respect the market, it incredibly hard to fathom it has the full capability of calculating the broad ramifications just on these new debt burdens alone as they filter through the economy. Bricks made most market data and historical evidence irrelevant throughout much of 2022 due to their violent nature.

These cross current ripples will eventually smooth out. As investors, knowing they eventually will is how we can mentally get through the turbulence of them as well as the facts that uncertainty brings the value in prices we want to buy into as long-term investors. I am confident on what this pond will look like once settled. We will use the ripples, when possible, with that vision in mind as we move forward. But we are still on our way out from this unique and multifaceted 2022 epicenter. For the time being, I believe it’s na?ve to throw caution to the wind and dive back in. Especially because investors appear far too eager and impatient to be back swimming once again.

To be expanded upon…without using the word “ripple” ever again..

Hope all is well,

-Trevor

Written in January & February exclusively, approved for distribution 3/13/2023

The comments in this letter are for general informational purposes. Information is based on sources believed to be reliable. The economic forecasts set forth in this commentary may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Past performance is no guarantee of future results

Investments are subject to risk, including the loss of principal. Because investment return and principal value fluctuate, shares may be worth more or less than their original value. Some investments are not suitable for all investors, and there is no guarantee that any investing goal will be met. Past performance is no guarantee of future results. Talk to your financial advisor before making any investing decisions. Diversification does not assure a profit or protect against loss in declining markets, and diversification cannot guarantee that any objective or goal will be achieved