By Mark Mowrey, CFA
5
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The podcast currently has 53 episodes available.
In this podcast, I lament the quick-draw narratives that seem to drive short-term market volatility.
This session, I ponder the motivations of and position our work against the "do this now!" punditry.
In this podcast, I provide some early glimpses of the power of artificial intelligence in practice. I also discuss some concerns I have for the technologies' broader usage in investment management and allow Microsoft's CoPilot to chime in.
Cash holdings may provide comfort, but inflation diminishes the value of uninvested cash over time. Outside of purchase delays and product substitutes, there is little more consumers can do to directly address inflation. Investors, on the other hand, have a range of options to address that potential drag. The greater the expected return of a portfolio, the potential greater success one may find in achieving financial goals, which may specifically include seeking to beat inflation. The constant caveat applies: the more return we seek the greater the risk we might not achieve that expected return:
Fair to suggest that a minimal expectation for any investment strategy is to maintain purchasing power over time, implying returns in excess of inflation (a positive “real” return). While that goal might seem straightforward enough, achieving it isn’t always so simple. To wit: for the better part of the last 15 years, U.S. inflation, as measured by the year-over-year change in the Consumer Price Index, ran hotter than the yield one could earn buying 1-month U.S. Treasury bills. With short-term bond yields now comfortably above latest U.S. inflation figures (consumer prices roses 3.2% year-over-year in July, versus a 1-month Treasury Bill yield of 5.3% at the end of June), investors can take on very little risk while seeking to ensure their savings maintain purchasing power. That short-term Treasury yields are higher than concurrent inflation marks a return to a relatively more normal situation: As we show in Figure 1, 1-month Treasury returns were above inflation just under three-fifths (57.8%) of the time since 1949.
Over longer periods of time, the rate of success improves. While a “most, but not all the time” success rate might fail to inspire confidence, one must remember that T-bill investors are assuming very little risk. There are various ways to address inflation more directly in portfolios, including the purchase of inflation-protected securities and inflation-targeting hedges. But such strategies may come with their own unique set of considerations and risks and may at best only directly offset inflation, rather than provide meaningful “real” gains.
As is generally the case when one seeks higher returns, “beating” inflation likely requires that investors assume greater risk. Equity investments may offer among the more straightforward options available to outgrow inflation. Looking back to Figure 1, while stocks achieve about the same rate of success over 1-month periods providing a return in excess of inflation as 1-month Treasury bills, the success rate for stocks improves more quickly and more substantially over time. In fact, over all historical 20-year periods and longer (using monthly returns), stocks historically have always outpaced inflation.
As we noted, however, the increasing historical success at beating inflation can be seen as compensation for having taken on the extra risk of not only not beating inflation, but even substantially underperforming inflation over shorter periods of time. Reflecting this view, Figure 2 shows the range of historical inflation-adjusted outcomes (we calculated the “batting average” in Figure 1 from the same set of data we summarized in Figure 2). For stocks, while the batting average might be better, the range of outcomes is much wider than that for 1-month T-bills. And that wider range has included substantially more negative outcomes than 1-month T-bills over shorter time frames.
Neither short-term Treasuries, nor stocks therefore guarantee a better-than-inflation outcome. Nonetheless, over shorter time frames, though Treasuries may have shown a weaker average chance of beating inflation, they’ve tended to have shown a far greater likelihood to have offered returns that have approximated inflation. Those results may still compare favorably to stocks, which have proved far more likely to disappoint—sometimes intensely so—over shorter time frames.
Regarding “when” T-bills have tended to underperform inflation, we have seen two general scenarios over the past century. The first, perhaps more obvious reason relates to occasions when inflation surprised to the upside. As we show in Figure 3, the late 1970s saw 1-month rates of inflation often exceed the concurrent levels of 1-month Treasury bills. That mismatch led to a long period of trailing 10-year returns that underperformed inflation. Only after the much higher interest rates of the very late 1970s and early 1980s were in effect did short-term Treasuries begin to provide inflation-beating trailing returns.
A surge in inflation over the last two years led to a similar drop into negative territory for real returns for 1-month T-bills. But that mismatch came on the heels of nearly two decades during which time short-term interest rates were generally below monthly rates of inflation. As the Federal Reserve held the federal funds rate (its short-term target for overnight inter-bank lending) near 0% on account of desires to stimulate macroeconomic activity and to avoid a potential deflationary environment, 1-month T-bills followed suit. But inflation generally hovered near the Fed’s long-term target of 2% nonetheless, the result being a repression of real returns for short-term Treasuries. The longer-term Fed-forced mismatch, followed by the recent spike in inflation proved a double whammy for trailing real returns.
A comparable inflation surge on the heels of World War II dragged down relative returns even 10 years later. After inflation subsided, however, relative returns were set up to outperform over the subsequent years. We tend to think we have entered a similar environment. With short-term rates in excess of inflation, so long as inflation continues to cool, real returns should remain reasonably positive.
Readers will want to note the “so long as” and “should” qualifiers in that sentiment. Naturally, going-forward relative returns will be entirely dependent on the realized returns of the various asset classes in consideration, versus each other and inflation. Deciding where to position portfolios in light of client comfort with those unknowable factors and the relative volatility across the range of asset classes suitable to individual client investment scenarios remains core to our work as financial advisors and portfolio managers.
Signature Resources Capital Management, LLC (SRCM) is a Registered Investment Advisor. Registration of an investment adviser does not imply any specific level of skill or training. The information contained herein has been prepared solely for informational purposes. It is not intended as and should not be used to provide investment advice and is not an offer to buy or sell any security or to participate in any trading strategy. Any decision to utilize the services described herein should be made after reviewing such definitive investment management agreement and SRCM’s Form ADV Part 2A and 2Bs and conducting such due diligence as the client deems necessary and consulting the client’s own legal, accounting and tax advisors in order to make an independent determination of the suitability and consequences of SRCM services. Any portfolio with SRCM involves significant risk, including a complete loss of capital. The applicable definitive investment management agreement and Form ADV Part 2 contains a more thorough discussion of risk and conflict, which should be carefully reviewed prior to making any investment decision. All data presented herein is unaudited, subject to revision by SRCM, and is provided solely as a guide to current expectations.
The S&P 500 Index measures the performance of the large-cap segment of the U.S. equity market.
The opinions expressed herein are those of SRCM as of the date of writing and are subject to change. The material is based on SRCM proprietary research and analysis of global markets and investing. The information and/or analysis contained in this material have been compiled, or arrived at, from sources believed to be reliable; however, SRCM does not make any representation as to their accuracy or completeness and does not accept liability for any loss arising from the use hereof. Some internally generated information may be considered theoretical in nature and is subject to inherent limitations associated thereby. Any market exposures referenced may or may not be represented in portfolios of clients of SRCM or its affiliates, and do not represent all securities purchased, sold or recommended for client accounts. The reader should not assume that any investments in market exposures identified or described were or will be profitable. The information in this material may contain projections or other forward-looking statements regarding future events, targets or expectations, and are current as of the date indicated. There is no assurance that such events or targets will be achieved. Thus, potential outcomes may be significantly different. This material is not intended as and should not be used to provide investment advice and is not an offer to sell a security or a solicitation or an offer, or a recommendation, to buy a security. Investors should consult with an advisor to determine the appropriate investment vehicle.
So long as one did not carry too substantial an amount of interest rate risk in portfolios, markets provided a solid foundation for generally positive returns over the past quarter and year. While fixed income returns have yet to register the now higher yields on offer (recall that yields up = price down in bonds), global stocks took off from the October bottom.
“Despite all that” is a common refrain when discussing stock performance over the past year. Though they fell behind in May, developed-market stocks nearly matched the performance of U.S. stocks. Emerging-market equities languished over the trailing twelve months.
In the States, Large-Cap Growth stocks once again took the lead last quarter, adding to substantially stronger gains for the prior year, during which time Growth generally outperformed Value across all sizes of stocks. Meantime, Value turned in a better quarter abroad, while coming in close to Growth over the prior twelve months.
Turning to fixed income, rates have proved remarkably volatile so far in 2023 as investors on several occasions seem to have been caught wrong-footed relative to evolving macroeconomic data and potential shifts in monetary policy. But the general trend was higher, leaving much of the domestic investment-grade bond market in the red for the trailing 3- and 12-month periods. Nonetheless, generally narrower credit spreads helped offset the impact of rising rates on corporate bond returns.
While it’s understandable that investors may get excited about future prospects of new industries and business models, that enthusiasm may need to be tempered when it comes to the associated investment cases. Early investors may see substantial gains from the immense risks they took on when potentially grand success was merely imagined. But even later buyers-in may be arriving when measurably optimistic prospects are still baked into the valuation pie. Past examples of the resulting heartburn may provide reason for caution:
One can argue that the outsized gains experienced by its largest stocks over the past few years have seen the domestic equity market become a good bit less diversified. Rising from near a tenth of the U.S. market in early 2016, the five biggest names in terms of market capitalization now account for more than 20% of the broadest market exposure and represent an even higher concentration when one looks at large-cap stocks alone. Definitionally, that heavier concentration may have allowed some investors to benefit from the gains that have led to that declining diversity. One naturally wonders, though, to what undue risks might the ongoing ownership of these now far weightier names expose investors. As with most things in investing, the answer must be a nuanced one. From our perspective, the ongoing risks are less about the size than they are about how that size has come about. Most meaningful: what happens if the optimistic investment themes that have been driving some of what we see as excess returns fail to meet expectations?
Given the expectations reflected in the current valuations of these large-cap, mostly technology-oriented names, we don’t doubt that investors in any one or all of the current Big-5 U.S. stocks could experience future disappointment. Such are the natures of corporate, industry and macroeconomic cycles. One need only review the jostling about for fifth position on that top-5 list to find a fine example of the consequences of a failure to achieve growth-oriented goals implied by a soaring stock price and accompanying valuations. Then arguably reflecting a “they’ll own the whole car market!” narrative, Tesla (TSLA) shares traded near $410 in November 2021. Investors who piled in on the way from $200 to $400—now that the stock made a round trip from that prior peak—may have learned the lesson that high multiples require lofty goals to be met for the stock just to stay still. Further gains require even loftier goals be set and eventually achieved. When fractures in the growth story multiply, however, valuations tend to do the opposite. Though the shares are close to double their beginning-of-year lows, the TSLA story still suffers from concerns regarding pricing pressures amidst growing competition and slowing growth.
As we show in Figure 2, long-term TSLA investors should not have found recent volatility surprising. Similarly, the most recent entrant into the Big 5 list, Nvidia Corporation (NVDA), is no stranger to wild swings in relative performance. While shares in the chipmaker have soared 250% from a more recent trough in October of last year, it was less than a year ago when the stock had fallen by two thirds from a post-pandemic peak, far exceeding the decline in the broader stock market. That run was sparked by beliefs that cryptocurrency mining and various other server- and gaming-related trends would push chip sales to the moon. Reality set in and investors saw fit to establish a more rationale perspective on the company’s prospects for growth.
Despite that lesson, here we go again, only this time with more feeling! Nvidia is now the poster child of the artificial intelligence (AI) craze that’s presumably behind the tech-stock outperformance highlighted earlier, having positioned itself as the premier source of chips specialized to serve as the hardware-based “brains” for AI. And for the software side of AI, Microsoft has begun to incorporate across its product lines technologies to which it gained access via investment in arguably the most notable player in the AI technology space, OpenAI. Microsoft also is pitching itself as a provider of the incremental computing power required to utilize AI tech. MSFT shares are up just under 40% year to date, versus the broader market’s 11-ish percent rise.
As Nvidia and Microsoft shares gain ground on the hopes for AI’s eventual hegemony and their roles in that conquest, neither their individual successes, nor the short- to long-term prospects for profits related to AI are in any manner certain by magnitude or even fact. More experienced investors may recall similar enthusiasm for the Internet in its very early days. Though we find the extent of the diversion from sane valuations very different for those two stocks and not near as dramatic as many examples from the Technology Bubble of 2000, we do find in current market dynamics similarities to those that took hold in the surge up to the Bubble’s bursting.
What came after the burst may be interesting to those wondering what to make of the current market environment. From late 2000 through 2003, while the broader market suffered a long hangover due to earlier excesses, Value stocks and small-cap stocks had a historic go of it, having been left behind the earlier tech-focused surge. As even more time passed, shares of many of the higher fliers that managed to stay aloft became relatively attractive from a valuation standpoint as investors remained skeptical even as earlier growth stories proved at least somewhat true. Indeed, shares in all the current Big 5 but Amazon have spent time over the past twenty years showing valuations approximate to or less expensive than the broader market. That fact suggests valuation- and quality-sensitive investors may well have found them worthy of emphasis within portfolios.
Experience from those days further indicates to us today’s heavily concentrated passive investment landscape presents a scene of opportunity. It’s perhaps both too late and too early for AI investments: too late as the initial rush already is well underway; too early as the potential capacity to deliver profit via the application of still-evolving AI technologies is yet mostly unknown. Indeed, if the history of the Internet is any guide, a wide set of companies across the investment landscape may see profit-enhancing benefits from AI, not just the “picks and shovels” providers like Microsoft and Nvidia.
Signature Resources Capital Management, LLC (SRCM) is a Registered Investment Advisor. Registration of an investment adviser does not imply any specific level of skill or training. The information contained herein has been prepared solely for informational purposes. It is not intended as and should not be used to provide investment advice and is not an offer to buy or sell any security or to participate in any trading strategy. Any decision to utilize the services described herein should be made after reviewing such definitive investment management agreement and SRCM’s Form ADV Part 2A and 2Bs and conducting such due diligence as the client deems necessary and consulting the client’s own legal, accounting and tax advisors in order to make an independent determination of the suitability and consequences of SRCM services. Any portfolio with SRCM involves significant risk, including a complete loss of capital. The applicable definitive investment management agreement and Form ADV Part 2 contains a more thorough discussion of risk and conflict, which should be carefully reviewed prior to making any investment decision. All data presented herein is unaudited, subject to revision by SRCM, and is provided solely as a guide to current expectations.
The opinions expressed herein are those of SRCM as of the date of writing and are subject to change. The material is based on SRCM proprietary research and analysis of global markets and investing. The information and/or analysis contained in this material have been compiled, or arrived at, from sources believed to be reliable; however, SRCM does not make any representation as to their accuracy or completeness and does not accept liability for any loss arising from the use hereof. Some internally generated information may be considered theoretical in nature and is subject to inherent limitations associated thereby. Any market exposures referenced may or may not be represented in portfolios of clients of SRCM or its affiliates, and do not represent all securities purchased, sold or recommended for client accounts. The reader should not assume that any investments in market exposures identified or described were or will be profitable. The information in this material may contain projections or other forward-looking statements regarding future events, targets or expectations, and are current as of the date indicated. There is no assurance that such events or targets will be achieved. Thus, potential outcomes may be significantly different. This material is not intended as and should not be used to provide investment advice and is not an offer to sell a security or a solicitation or an offer, or a recommendation, to buy a security. Investors should consult with an advisor to determine the appropriate investment vehicle.
Over the four-plus decades since Americans last braced against a high-inflation environment, investors have seen interest rates sink to fresh lows and rise to lower peaks with each successive economic cycle. Rates are well off recent depths on account of ongoing efforts to ease upward price pressures, bringing positive and negative impacts along with:
In each of the three major market crises since the turn of the millennium—the Tech Bubble, the Great Financial Crisis (GFC) and the COVID-19 Pandemic—the Federal Reserve pushed interest rates lower to foster an investment environment more amenable to growth-as-cure remedies. As the sharper impacts of those crises abated, the Fed sought to withdraw its theretofore extraordinary market support. Prior to each subsequent dislocation, though, interest rates never returned to their prior “normal” before realizing new lows on account of even more creative and aggressive attempts by the Fed to maintain proper market function and provide a foundation for macroeconomic stability. By the summer of 2020, rates on U.S. Treasury securities languished at levels not seen in history. Among the consequences of those paltry yields was the increasing inability of savers to look to bonds to generate income.
Post-GFC, various forces left the Federal Reserve (and other central banks around the globe) concerned about deflation, or insufficient upward pressure in prices, which is thought to hamper macroeconomic growth. We’re collectively still learning about these forces to this day, but the list is thought to include increased regulation of the financial sector and the sobering effects, including heightened fiscal austerity, that tend to come along with financial crises.
Conversely, the path to “normal” interest rates after the pandemic has seen central banks fighting burdensome levels of inflation, or too much upward pressure on prices. We’ll similarly for years be pondering aloud the drivers that have resulted in the highest rates of inflation the U.S. has experienced since the early 1980s, with the list of influences currently thought to include easy-for-too-long Federal Reserve policies and way-too-generous fiscal responses to pandemic-related macroeconomic issues in the form of cash handouts, debt repayment delays and outright forgiveness.
Seeking to quash high and sticky inflation, the Federal Reserve has in a historically abrupt manner raised its target for very short-term lending from an upper bound of 0.25%, established on 03.16.20 to ease financial conditions to counter the effects of the COVID-19 pandemic, to 5.00% on 03.22.23, the highest that target has been since September 2007. While still volatile and well off recent peaks, 6-month average yields on portions of the U.S. Treasury market, in tune with the Fed’s shift in policy, are at levels not seen since the mid- to late-2000s. We chose to show the 6-month average in Figure 1 because, for various reasons, the most impactful of which we’ll get to in a moment, interest rates have proved quite volatile this year. So, we “slowed down” the data (see the February 2023 commentary) to show how meaningfully rates have risen over the past year and a half.
Even so, while shorter-term interest rates (i.e., on bonds maturing in 6 months or sooner) express the likelihood that the Federal Reserve will retain its policy stance in the very near term, yields on bonds maturing over the medium term suggest greater investor uncertainty regarding the potential success of the Fed’s restrictive policies (see Figure 2). It all gets very messy when one attempts to figure out the minds of bond investors, but the thinking is as follows. Longer-term rates have tended to fall relative to short-term rates as inflation trends worsened and/or investors expressed stronger beliefs that to win the fight against inflation, the Fed would have to foster a recession (meaning the Federal Reserve might need to raise rates higher or keep them higher for longer, while potentially in short order having to reverse rate hikes to provide support against a recession). Longer-term rates have tended to rise relative to shorter-term rates as investor fears regarding a potential nearer-term recession eased and/or trends in inflation turned more positive than expected (meaning the Federal Reserve might not need to raise rates as high or keep them high for as long, while not having a reason to reverse rate hikes). The short of it is: investors strain against potentially opposing beliefs that interest rates are sufficiently high to tame inflation, but not so high to spark a recession and a dramatic shift higher in unemployment.
And much of that strain comes from whether the investor believes the Fed’s present stance is one of: still accommodative, less accommodative, neutral, restrictive or overly restrictive. Folks on the “still accommodative” end of that spectrum are more likely to believe that inflation has much more room to run, while those on the “overly restrictive” end likely believe a recession is soon to come. Anywhere in between those two extremes, though, one could maintain beliefs that rest within any matrix defined by opinions on the ongoing impacts of higher interest rates on macroeconomic growth and employment. That is, one could think that Fed policy is sufficiently restrictive and that the policies will result in a taming of inflation, but that a strong recession with many jobs lost might be required for that expectation to prove accurate. Others could agree on the first two bits but think that the economy could muddle through without a recession or a substantial increase in unemployment. As opinions have evolved along with additional Fed policy moves and new data, portfolio decisions will have boosted bond market volatility. That medium-term interest rates presently are so much lower than short-term rates may mean that investors in the aggregate (at least presently) maintain the belief that the Fed is likely to spur a recession that forces an about-face on rate hikes and a return to an accommodative policy stance (see the top part of Figure 2).
However, the Federal Reserve—as expressed in forecasts for interest rates and inflation—to a measurable extent seems to disagree with the bond market on the path presently suggested by the bond markets (by “path” we mean to express the understanding that various bond market measures reflect where investors believe future short-term interest rates will be, accepting that some of that information relates to a premium generally demanded by investors for assuming the risk of an unknowable future). Compared to current yields, expectations for interest rates over the next two years voiced by members of the Federal Reserve Board of Governors remain a good bit higher than those expressed in the current yield curve.
And that gap expanded on account of investor uncertainty regarding the solvency of many smaller members of the U.S. banking system (see in Figure 2 how the yield curve has shifted since the beginning of the year). We provided a market update on March 13 in which we discussed the financial sector tremors, the gist of which is that a host of banks were feeling the consequences of the rapid rise in rates, which left a bulk of their otherwise relatively safe assets underwater. To raise funds to meet depositor withdrawals, the banks were pressured to sell in-the-red securities and lock in those losses. Such sales could impact a bank’s solvency and ability to meet additional requests for withdrawals. A factual component of the failure of Silicon Valley Bank, when large depositors at these banks caught wind of those potential stresses on bank liquidity, which might result in some portion of their deposits not being immediately (or even ever) available, many of those depositors sought to withdraw their monies. Too many such withdrawals over a short time frame and you have what’s known as a bank run. After three banks failed as a result of a rush to the exits, the Federal Reserve and the U.S. Treasury instituted several programs (presently understood to be relatively short-term) to both support the banking system and calm depositor nerves. Seems those programs have so far seemingly succeeded in both areas, but time will tell.
Arguably[1] both an eventual outcome of interest rates that were too low for too long and a direct result of interest rates that rose too high too quickly, stress across the banking sector may have knock-on macroeconomic effects. As banks are forced to reckon with limited liquidity, they may need to pull back on lending. Such a retrenchment in lending is one of the intended impacts of the Federal Reserve’s rate hikes. Higher costs to borrow, along with less availability of and stronger requirements for borrowing may mimic the impact of higher rates. Estimates vary, but opinions suggest that bank-related strains might work like an extra 0.25% to 0.50% rate hike. That potential influence has further contributed to heightened interest rate volatility over the past few weeks as investors incorporate evolving expectations for future Federal Reserve policy decisions in light of these potential add-on effects.
Nonetheless, according to the bulk of Federal Reserve commentary, inflation remains top of mind, even as financial market stability diverts some of that attention. And that stance in part contributes to the gap in expectations for the path of interest rates of the medium term. To combat inflation, the Fed will continue to implement interest rate-focused tools. Meantime, the Fed and the Treasury will use complementary programs, not specifically focused on interest rates, in order to maintain stability within the banking sector. One should remember that, per the Federal Reserve and the Treasury (yes...mostly vaguely and perhaps a bit counterproductively; listen to this month’s podcast for more on that), these deposits are not evaporating. Rather, they’re generally just moving to pastures perceived by the depositors as safer. And for those reasons, this episode of banking sector folly seems to us (and many other seemingly rational folks) still to be residing on the manageable side of the crisis scale.
As we noted earlier (perhaps a bit optimistically, but not wrongly), the Fed’s efforts to stabilize banks need not be seen as working against its efforts to fight inflation. Of course, neither has inflation been tamed, nor has the banking system moved past these latest tensions. A fresh spark could incite a fresh run. And services-related pricing pressures may prove more durable, while goods-related inflation could rise anew. Meantime, we’re far from knowing that a recession will prove the result of the combined impacts of the shift in monetary policy and banking stress, but that probability may have increased due to the latter. For now, however, though success in either endeavor is neither assured, nor likely imminent, we continue to think that the Fed is demonstrating that it can manage toward both objectives and that both aims ultimately will be met.
We’ll offer the additional reminder that U.S. stocks remain well below their prior peaks, while history shows that markets have tended to have dropped on account of the potential of a near-term recession and to have rebounded from near-term lows before a recession is officially declared (see our July 2022 commentary). Even so, we understand that readers may have concerns regarding current portfolio allocations in the context of all that we’ve discussed in this commentary. As always, we are happy to discuss those concerns as desired.
Signature Resources Capital Management, LLC (SRCM) is a Registered Investment Advisor. Registration of an investment adviser does not imply any specific level of skill or training. The information contained herein has been prepared solely for informational purposes. It is not intended as and should not be used to provide investment advice and is not an offer to buy or sell any security or to participate in any trading strategy. Any decision to utilize the services described herein should be made after reviewing such definitive investment management agreement and SRCM’s Form ADV Part 2A and 2Bs and conducting such due diligence as the client deems necessary and consulting the client’s own legal, accounting and tax advisors in order to make an independent determination of the suitability and consequences of SRCM services. Any portfolio with SRCM involves significant risk, including a complete loss of capital. The applicable definitive investment management agreement and Form ADV Part 2 contains a more thorough discussion of risk and conflict, which should be carefully reviewed prior to making any investment decision. All data presented herein is unaudited, subject to revision by SRCM, and is provided solely as a guide to current expectations.
The opinions expressed herein are those of SRCM as of the date of writing and are subject to change. The material is based on SRCM proprietary research and analysis of global markets and investing. The information and/or analysis contained in this material have been compiled, or arrived at, from sources believed to be reliable; however, SRCM does not make any representation as to their accuracy or completeness and does not accept liability for any loss arising from the use hereof. Some internally generated information may be considered theoretical in nature and is subject to inherent limitations associated thereby. Any market exposures referenced may or may not be represented in portfolios of clients of SRCM or its affiliates, and do not represent all securities purchased, sold or recommended for client accounts. The reader should not assume that any investments in market exposures identified or described were or will be profitable. The information in this material may contain projections or other forward-looking statements regarding future events, targets or expectations, and are current as of the date indicated. There is no assurance that such events or targets will be achieved. Thus, potential outcomes may be significantly different. This material is not intended as and should not be used to provide investment advice and is not an offer to sell a security or a solicitation or an offer, or a recommendation, to buy a security. Investors should consult with an advisor to determine the appropriate investment vehicle.
[1] Many believe the present state of inflation and banking troubles are purely faults of Federal Reserve policy. We’d disagree about the “purely” bit (e.g., COVID-related fiscal programs likely were far too generous and, proverbially, banking execs will be banking execs...), but believe there’s sufficient evidence there for blame. Of course, vague counterfactuals generally are of little use and serve mostly to enable those offering the criticisms a chance to pretend that they have the basis for an, “I told you so!”
In recent months we’ve sought to highlight the notion that investment markets are forward-looking, meaning that they tend to reflect aggregate investor views as to where global economies and the countries and companies that operate within them are heading, rather than where they’ve been. But what does that mean, exactly?
Where we’ve been and where we presently are often matter less to investors than where we’re heading. Of course, where we’ll end up near always requires inexact estimation. Happily, the world offers a bounty of finance- and investment-related metrics that can be used to develop forecasts. Forecasts often are based on the extrapolation of current trends. And to measure trends and gauge their durability, we tend to focus our math on the direction and pace of change in data. To demonstrate just such a review, we’ll turn again to the metric of the moment: inflation. A measure of the year-over-year change in prices, inflation can be “noisy”, in that it can jump around on a month-to-month basis. And given that noisiness, one should not expect next month’s reading to be favorable just because the latest reading offered good news. It helps, instead, to think of each new reading as just another datum in a long series and that we actually can gain more insight into the present and future state of affairs by taking a step back and placing new data in the context of earlier reports.
For example, to get a better idea of the direction of change in such data, we can “smooth” the series by computing a “rolling” average. This smoothing will tend to highlight more durable changes, in that the math allows similarly directional movements to stack, resulting in a derivative series that may provide a better sense of the direction of change. In Figure 1, we perform just such math on inflation. We chose the Consumer Price Index as the basis for the review but opted for the version of that index that excludes food and energy. Food and energy prices tend to be more volatile than the prices for other goods and services. Removing them therefore already begins to smooth the inflation data into a series from which we may be able to determine a core trend.
After charting the base series, in the next component of the figure we show a “signal” chart that reflects the change for each month: green for lower rates of inflation and grey for higher rates. Notable is the fact that this series of signals, too, tends to bounce around, making each new data point a not-so-reliable indicator of future short-term shifts. To wit, there are two key points in that series (see the blue boxes in the figure) that show why we might not wish to focus on the latest monthly data alone as clues as to where inflation was heading. In July and August 2021, inflation eased to 4.3% and 4.0%, in that order, from the June reading of 4.5%. But this downturn proved short-lived. Inflation fell again each month from April through June of 2022, ending at 5.9%. Another head fake: inflation rose further to what we hope will prove its peak for this cycle of 6.6% in September 2022.
Eyeing those potential pitfalls, there’s a potentially more informative way to look at the data. We could take the noisy monthly data series and slow it down by averaging values over trailing periods. For example, for each month in the series, you could average the value of that month and those of the two months prior to arrive at a “rolling” 12-month average (we also could refer to this series as a “trailing” 12-month average, which incorporates both the rolling aspects and the fact that we assign each 12-month average to the last month in the 12-month series). By averaging those twelve months of data, you’ll tend to tease out the wobbles each month presents to uncover the underlying waves of data. The wider the “window” of the rolling period, the slower and smoother the series generally will become. We can then compare, as we do in the final chart of Figure 1, the smoothed series to the underlying series to compare latest data to trend. And what do you know…it might just be that a period of disinflation has begun, considering the fact that the December value of 5.7% (latest value) was the first reading released in a long time that fell below the 12-month average.
We might not stop there, however. Again, the underlying series remains noisy, so we still might not wish to place too much weight on the latest value alone. Adding further depth to the analysis, we might like to compare a somewhat smoothed, short-term series (e.g., a trailing 3-month value) with a more meaningfully smoothed, long-term series (e.g., a trailing 12-month value). We’ve done this in Figure 2, where we see that inflation still seems to be trending down, even though the average of readings from the latest three months is higher (at 6.0%) than the value for December (5.7%).
Importantly, even this arguably higher-conviction indicator is by no means confirmation that an actual durable downtrend in inflation has occurred. As we noted last month, the price series underlying the CPI maintain distinct directions and paces of change. While goods prices generally have been easing, services prices have proved more stubbornly inflationary. We chart these differences in Figure 3, where we see that, while goods prices have been trending lower for some time now, services prices are still heading higher.
In his press conference on Wednesday, February 1, after the Federal Reserve announced that it was raising its target for the fed funds rate to between 4.50% and 4.75%, Fed Chairman Jerome Powell said the word “disinflation” or some form of it at least 15 times (judging from the transcript). While he welcomes the relatively more favorable price trends, he acknowledged that his team’s task to suppress inflation is not yet complete, and that there may be, “a couple more rate hikes” in the future before the Federal Reserve is ready to declare an end to this rate-hike cycle.
Seemed markets heard none of that, though. Bonds markets still suggest the Fed is likely to begin cutting rates before the year is out, perhaps under the belief that interest rates are already so restrictive that something more than a mild recession is in store later this year after the Fed implements a few more hikes. And the (inferred) observation that Chairman Powell did not seem too disturbed by an easing in financial conditions that otherwise might put upward pressure on prices (be inflationary)—including the shift lower in longer-term rates and the stock market’s bounce from its October low—saw stocks surge through to the close and still higher the day after.
Perhaps the positive reaction to the news on the stock front was excessive. There were no more data offered during the press conference. And, if anything, Chairman Powell reiterated the planned trajectory of interest rates. So, stock investors may simply be coming around to the idea that the worst of post-pandemic inflation is behind us. After all, the U.S. market is still more than 12% below its January 2022 peak. As for bonds, we remain confident in our decision to maintain a cap on exposure to longer-duration bonds, both for the enhanced yield available across shorter-duration bonds and the potential for longer-term yields to remain volatile against incoming data oppositional to the narrative that seems to support current positioning across the U.S. bond markets.
Signature Resources Capital Management, LLC (SRCM) is a Registered Investment Advisor. Registration of an investment adviser does not imply any specific level of skill or training. The information contained herein has been prepared solely for informational purposes. It is not intended as and should not be used to provide investment advice and is not an offer to buy or sell any security or to participate in any trading strategy. Any decision to utilize the services described herein should be made after reviewing such definitive investment management agreement and SRCM’s Form ADV Part 2A and 2Bs and conducting such due diligence as the client deems necessary and consulting the client’s own legal, accounting and tax advisors in order to make an independent determination of the suitability and consequences of SRCM services. Any portfolio with SRCM involves significant risk, including a complete loss of capital. The applicable definitive investment management agreement and Form ADV Part 2 contains a more thorough discussion of risk and conflict, which should be carefully reviewed prior to making any investment decision. All data presented herein is unaudited, subject to revision by SRCM, and is provided solely as a guide to current expectations.
The opinions expressed herein are those of SRCM as of the date of writing and are subject to change. The material is based on SRCM proprietary research and analysis of global markets and investing. The information and/or analysis contained in this material have been compiled, or arrived at, from sources believed to be reliable; however, SRCM does not make any representation as to their accuracy or completeness and does not accept liability for any loss arising from the use hereof. Some internally generated information may be considered theoretical in nature and is subject to inherent limitations associated thereby. Any market exposures referenced may or may not be represented in portfolios of clients of SRCM or its affiliates, and do not represent all securities purchased, sold or recommended for client accounts. The reader should not assume that any investments in market exposures identified or described were or will be profitable. The information in this material may contain projections or other forward-looking statements regarding future events, targets or expectations, and are current as of the date indicated. There is no assurance that such events or targets will be achieved. Thus, potential outcomes may be significantly different. This material is not intended as and should not be used to provide investment advice and is not an offer to sell a security or a solicitation or an offer, or a recommendation, to buy a security. Investors should consult with an advisor to determine the appropriate investment vehicle.
Most years see some manner of substantial decline in stocks, even as most full-year tallies turn out positive. This year has proved an exception to that tendency. Thus far, at least—there’s still about a month to go. With stocks well off the trough for the year, but still far from their peak at the start of 2022, many are wondering what’s to come next. We’re not much for specific predictions, so readers will hear echoes of our broader investment approach in our thoughts for 2023:
History shows that most years, U.S. stocks have seen positive returns. This year so far has bucked that norm. With only a month to go, seems quite possible we may not see the broader market turn positive by New Year’s Eve. Despite the nearly 14% rebound from October’s low, we’ve have heard more than a few folks suggesting the worst hasn’t yet been seen from this latest equity drawdown. That recession is nigh and stocks will plunge in sympathy at some point next year. Such pessimism seems always the easier note to strike when the market’s down and the rebound seems set upon a shaky foundation. But honest folks will admit they have no idea how next year’s market will perform and that whatever specific forecast they are offering must sit within a range of outcomes that include both better and worse scenarios. Of course, a wide range of potential outcomes is par for the course of equity returns, as our next chart demonstrates.
Looking at market returns only through the January-to-December lens masks the fact that stocks are pretty volatile over any 12-month period, including those that don’t begin in January. Starting from the beginning of 1926, there have been 1,152 12-month periods through the end of November 2022. The median return of the S&P 500 Index across those “rolling” periods was 13.2%. Well distant from the far more extreme drops seen in history, the S&P’s decline of 9.2% (including dividends) over the past 12 months (November 2021 through November 2022) sits well within the range of values that most results fall.
And that range has a positive bent: more than three-quarters of rolling 1-year returns have been positive. Sequential down years are possible for sure, and the U.S. stock market has seen very long periods over which investors would have lost money, but the longer we look out into the future, the greater the propensity for returns to have been positive. Not all can maintain such patience in the face of market volatility, though. So will take the opportunity of the year’s close to remind readers to reach out to an advisor to discuss any shifts in comfort with exposure to market risk, as well as any changes in financial situations and goals.
Speaking of looking to the future, wishing everyone a safe a festive close to 2022 and a grand launch into the new year.
Signature Resources Capital Management, LLC (SRCM) is a Registered Investment Advisor. Registration of an investment adviser does not imply any specific level of skill or training. The information contained herein has been prepared solely for informational purposes. It is not intended as and should not be used to provide investment advice and is not an offer to buy or sell any security or to participate in any trading strategy. Any decision to utilize the services described herein should be made after reviewing such definitive investment management agreement and SRCM’s Form ADV Part 2A and 2Bs and conducting such due diligence as the client deems necessary and consulting the client’s own legal, accounting and tax advisors in order to make an independent determination of the suitability and consequences of SRCM services. Any portfolio with SRCM involves significant risk, including a complete loss of capital. The applicable definitive investment management agreement and Form ADV Part 2 contains a more thorough discussion of risk and conflict, which should be carefully reviewed prior to making any investment decision. All data presented herein is unaudited, subject to revision by SRCM, and is provided solely as a guide to current expectations.
The opinions expressed herein are those of SRCM as of the date of writing and are subject to change. The material is based on SRCM proprietary research and analysis of global markets and investing. The information and/or analysis contained in this material have been compiled, or arrived at, from sources believed to be reliable; however, SRCM does not make any representation as to their accuracy or completeness and does not accept liability for any loss arising from the use hereof. Some internally generated information may be considered theoretical in nature and is subject to inherent limitations associated thereby. Any market exposures referenced may or may not be represented in portfolios of clients of SRCM or its affiliates, and do not represent all securities purchased, sold or recommended for client accounts. The reader should not assume that any investments in market exposures identified or described were or will be profitable. The information in this material may contain projections or other forward-looking statements regarding future events, targets or expectations, and are current as of the date indicated. There is no assurance that such events or targets will be achieved. Thus, potential outcomes may be significantly different. This material is not intended as and should not be used to provide investment advice and is not an offer to sell a security or a solicitation or an offer, or a recommendation, to buy a security. Investors should consult with an advisor to determine the appropriate investment vehicle.
The S&P 500 Index measures the performance of the large-cap segment of the U.S. equity market.
One cannot invest directly in an index. Index performance does not reflect the expenses associated with the management of an actual portfolio. Investing in any investment vehicle carries risk, including the possible loss of principal, and there can be no assurance that any investment strategy will provide positive performance over a period of time. The asset classes and/or investment strategies described in this publication may not be suitable for all investors. Investment decisions should be made based on the investor's specific financial needs and objectives, goals, time horizon, tax liability and risk tolerance.
Seems reasonable to expect that corporate earnings are likely to fall on account of inflation-induced weaker profitability and a slowdown in revenue growth. The growth-stall is likely to stem in part from the Federal Reserve’s efforts to tame that margin-crushing inflation, as the Fed directly intends to provoke a slowdown in macroeconomic activity, perhaps even a U.S. recession, in order to alleviate upward pressures on prices. Data have supported those expectations, but perhaps not as dramatically as many folks might have thought…or hoped. Several aspects of this gap are worth noting:
Driven by commentary provided by corporate executives and likely filtered through each analyst’s individual lens on corporate America, earnings expectations for companies within the S&P 500 Index have dropped rather steadily since the middle of this year. These trends surely reflect ruminations on the potential impacts of more restrictive monetary policy, which might slow top-line growth, set against persistent inflation, which could pressure profit margins, along with the evolution of the war in Ukraine and myriad other considerations. For the current calendar year, estimates are just about where they were at the beginning of 2022, though the rainbow-like route those estimates took include a growing deceleration since July. Even so, the pace of decline in optimism has remained rather steadyish in tempo. As importantly, the annual growth figures for the next few years remain positive, at least for now.
The story isn’t the same for all sectors, though. The Energy and Materials sectors express two different outlooks for prices: energy prices may remain high, while prices for many other raw materials may continue to fall through next year. And oncoming macroeconomic weakness can be seen in the divergence in expected fortunes of the cyclical Consumer Discretionary group relative to the generally more stable Consumer Staples group. With the exceptions of Energy and Utilities, expectations for which remain higher now than in the summer, earnings forecasts at the sector level are flat at best from summertime views, with dramatic declines far more common.
So earnings expectations in the aggregate hide contradictory trends underneath. Even with that understanding, many commentators still seem rather confident that the data—maybe all the data—are a ruse. That corporate execs might be telling half-truths in order to let investors down lightly as sales and margins deteriorate more quickly than their outlooks suggest. Or even worse (and more cynically), not divulging their dire circumstances for fear of scuttled year-end bonuses. On the flip side, execs might be telling the full truth as they presently perceive it, thereby demonstrating that the economy is not slowing sufficiently and that inflation will prove more persistent than desired such that the Fed will have to work harder for longer to tame it, potentially leading to a worse-than-now-expected recession.
Either of those beliefs suggest another market dislocation is in order: from a kitchen-sink acknowledgement that earnings are much worse than folks had expected or that the outlook for monetary policy will have to become much more restrictive than presently thought. Neither is out of the question. In fact, some manner of both is possible.
But that does not mean a market dislocation is a required result of some or all of both being true. Much depends on the rate of recognition of an environment being different than earlier had been thought. To the extent that the changes continue along a path of incremental deterioration (within some range of lower-bounds, of course), investors may find that the present still hefty drawdown in equity markets relative to the January peak, along with much higher interest rates (compared to the past decade, at least) sufficiently acknowledge potential circumstances. Still more volatility would likely be in store, but perhaps not substantial additional downside.
Of course, a more dramatic shift in trend is possible. But such is the nature of the uncertainty that comes along with investing. The “risk” part of the risk premium that is demanded by the expected return that investing is meant to present. As always, we are happy to discuss the potential ramifications of any such potential surprises on existing and/or considered portfolio exposures.
Signature Resources Capital Management, LLC (SRCM) is a Registered Investment Advisor. Registration of an investment adviser does not imply any specific level of skill or training. The information contained herein has been prepared solely for informational purposes. It is not intended as and should not be used to provide investment advice and is not an offer to buy or sell any security or to participate in any trading strategy. Any decision to utilize the services described herein should be made after reviewing such definitive investment management agreement and SRCM’s Form ADV Part 2A and 2Bs and conducting such due diligence as the client deems necessary and consulting the client’s own legal, accounting and tax advisors in order to make an independent determination of the suitability and consequences of SRCM services. Any portfolio with SRCM involves significant risk, including a complete loss of capital. The applicable definitive investment management agreement and Form ADV Part 2 contains a more thorough discussion of risk and conflict, which should be carefully reviewed prior to making any investment decision. All data presented herein is unaudited, subject to revision by SRCM, and is provided solely as a guide to current expectations.
The opinions expressed herein are those of SRCM as of the date of writing and are subject to change. The material is based on SRCM proprietary research and analysis of global markets and investing. The information and/or analysis contained in this material have been compiled, or arrived at, from sources believed to be reliable; however, SRCM does not make any representation as to their accuracy or completeness and does not accept liability for any loss arising from the use hereof. Some internally generated information may be considered theoretical in nature and is subject to inherent limitations associated thereby. Any market exposures referenced may or may not be represented in portfolios of clients of SRCM or its affiliates, and do not represent all securities purchased, sold or recommended for client accounts. The reader should not assume that any investments in market exposures identified or described were or will be profitable. The information in this material may contain projections or other forward-looking statements regarding future events, targets or expectations, and are current as of the date indicated. There is no assurance that such events or targets will be achieved. Thus, potential outcomes may be significantly different. This material is not intended as and should not be used to provide investment advice and is not an offer to sell a security or a solicitation or an offer, or a recommendation, to buy a security. Investors should consult with an advisor to determine the appropriate investment vehicle.
The S&P 500 Index measures the performance of the large-cap segment of the U.S. equity market.
One cannot invest directly in an index. Index performance does not reflect the expenses associated with the management of an actual portfolio.
Investing in any investment vehicle carries risk, including the possible loss of principal, and there can be no assurance that any investment strategy will provide positive performance over a period of time. The asset classes and/or investment strategies described in this publication may not be suitable for all investors. Investment decisions should be made based on the investor's specific financial needs and objectives, goals, time horizon, tax liability and risk tolerance.
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