“In investing, what is comfortable is rarely profitable.”
– Robert Arnott
LOOKING BACK, LOOKING FORWARD
Blindsided by one of the "known unknowns" that are always lurking in the background and
can upset existing market narratives, markets reacted to Q1's rising inflation. Investor
expectations coming into 2022 were modest – economic growth may come slowly but
remain solid, and stocks were forecast to rise, though not at the pace of 2021.
In the new year, investors were fully aware that inflation was proving more durable than
"transitory" and that interest rates could head higher. Yet, it was only upon the turn of a
calendar page that investors seemingly contemplated what that potentially meant, i.e.,
a more aggressive Fed, a slowdown in corporate earnings growth, and a devaluing of
high-growth companies whose earnings may be in the distant future.
In one respect, the market correction in the first quarter (defined as a decline of 10-20%
from recent market highs) shouldn't have come as a surprise to experienced investors
since there have been 27 such declines since World War II, with the last one occurring
in 2018. By historical standards, a correction was overdue. Past corrections have had an
average decline of 13.7% and last for about four months (not including corrections that
turn into bear markets, i.e., a decline of 20% or more).
Nevertheless, historical performance is only a guide, not a guarantee of the future. So,
as investors look forward, they may see three significant headwinds for the market:
inflation, higher interest rates, and potentially wider geopolitical issues.
While a tighter monetary policy is the Fed's primary tool in fighting inflation, its ability to
dampen inflation over the near- to intermediate-term may be limited since higher interest
rates take time to work through the economic system. Also, a tighter monetary policy will
do very little to solve current supply chain problems – a significant contributor to rising prices.
While higher rates may be effective for lowering inflation longer term, it may come at a
short-term cost to investors. Higher interest rates, along with any shrinking of the Fed's
balance sheet, has reduced liquidity in the markets, which has put some downward
pressure on stocks.
The wild card seems to be what Russia does next, which could be as disparate as agreeing
to a withdrawal from Ukraine with a promise to respect Ukraine’s territorial integrity to the
highly unlikely but concern of invading additional countries and ratcheting up tensions with
A peaceful resolution to the Ukraine crisis may be met with deep relief by investors,
potentially allowing markets to rally and return the focus to economic fundamentals, like
GDP growth, inflation, and corporate profits. A widening of tensions could prove problematic
to the financial markets and the economy.
We've seen markets unsettled by war in the past. They tend to regain their balance in a
relatively short period. I’ve shared the charts in the past, but 5 out of the last 5 times
there were invasions, markets set the low on the day of the invasion. So far, this is true
in this situation as well.
THE DOG IS LURCHING IN MANY DIRECTIONS
One can compare the stock market to an excitable dog on a very long leash. The least bit
of stimulus and it begins darting randomly in every direction. The dog's owner may be
walking northeast to the park. At any one moment, there is no predicting which way the
pooch will lurch. But in the long run, you know he's heading northeast at an average speed
of three miles per hour and is going to the park. What is astonishing is that almost all the
market players, big and small, seem to have their eye on the dog, and not the owner. After
all, we know where the owner is headed and where he will eventually be. Yet, we cannot take
our eyes off the dog. This is why Warren Buffet says he wishes the market would just shut
down for years at a time. We wouldn’t be able to react to the dog’s every move and just know
we’ll see Fido and his owner at the park.
There are several distractions for this “pup-like” market.
Inflation distraction. Costs are rising across the board. From used cars to gasoline to housing
to food, most everything costs more than it did last year.
Fed tightening distraction. Interest rates are going up and easy money policy is going away.
When you print trillions of dollars and throw it into an economy, prices are going to go up. It
is inevitable. Add those trillions of dollars to a supply constrained economy and the prices
move up even faster. This is where we are. The good news is while the Fed is beginning to
raise rates, the free market is doing a lot of the heavy lifting. The Fed raised rates one quarter
of one percent in April, yet mortgage rates have risen almost one full percentage point in the
last 30 days. Higher mortgage rates will slow housing affordability, which in turn should begin to
put pressure on ever increasing home prices. As borrowing costs increase, there will be less
spending. Eventually, less spending puts downward pressure on prices.
COVID-19 distraction. While waning in the U.S., the specter of another wave keeps some
investors nervous. China’s zero case policy didn’t work and now its ripping through the country
just like it did everywhere else. This brings us to our next distraction.
Supply chain distraction. While the temporary shutdowns in China may exacerbate short-term
supply constraints, most of the damage was done during the long shutdowns of 2020. Throw in
a few extra trillion dollars of demand (thanks to the Fed) and manufacturing just hasn’t been able
to catch up. Yet. The best cure for high demand and high prices is higher prices. As I mentioned
above, borrowing is becoming less affordable and will eventually curb spending. As spending slows,
manufacturing will have a chance to catch up. Supply chains and shipping have been improving
lately. Again, the temporary shutdowns in China may temporarily delay the recovery, but as quickly
as Omicron moves in, it tends to move out just as fast.
Geopolitical distraction. Russia invades Ukraine. While the burden is quite heavy for the people of
Ukraine, history has shown events like this to be temporarily disruptive to the world economy. This
doesn’t take away from the cruelty the Ukrainian people are enduring. Invading a sovereign nation
in today’s world should be met with harsh consequences. Debilitating economic sanctions will
eventually work to slow Russian resolve. With all these distractions, there are other clues we must
Labor productivity is at an all-time high.
Unemployment is very low. Anyone who wants a job can have not just one, but two.
Innovation is still happening.
Again, the free market is doing some of the heavy lifting for the Fed. American, Chinese and
European consumers are facing various headwinds which will work synergistically to curtail
borrowing and spending. This means the Fed may actually have to do less tightening than
anticipated. The jury is out on how much the Fed has to do, but the free market is far more
efficient than government bureaucrats.
Finally, there are some technical indicators which point to the market low set in February being
the low of this cycle. There is no forecasting tool that is 100% accurate, but 8 of 9 times markets
were higher a year out using these indicators.
If you remember one of the themes of last quarter’s commentary, you may remember the four
words that can best summarize Horizon Preference… “This too shall pass.”
The following is an excerpt from a recent weekly commentary I sent out. It may be more accurate
now than it was few weeks ago. There is a lot of negativity out there currently, but I will leave you
This past weekend despite the negative news and high gas prices, families took their kids to Disney
World. They went to soccer, softball, baseball and volleyball games, then went out to dinner at local
restaurants. Americans across the country went to Walmart, Target, Lowes, Home Depot and here in
the south, Publix, and they bought things they wanted or needed. The Amazon, UPS and FedEx
trucks were also busy delivering eagerly anticipated items to those who ordered them.
My neighbors had a wedding in their back yard and I’m sure there were weddings all across America.
Imagine that, a bear market can't kill love. Ha. I’m getting soft in my advanced years. So, families are
being formed and doing what they tend to do… grow, work and spend money. The consumer drives
the economy, not CNN or Fox News. Yes, higher gas prices for a long time could shift where some of
that money is spent, but you are still going to be you and you are still going to want to go out and do
things. The human spirit tends to find a way even when it seems like there might not be one. I can’t
tell you what the market is going to do in the next few months, but I wouldn't bet against you.
Our portfolios remain invested in businesses that, in aggregate, generate solid cash flow and maintain
strong balance sheets. In today’s market environment, even great companies will experience some
volatility. The reality is one must remain invested through all markets to be a successful investor.
Trying to time or jump in and out the market based on sentiment has proved to be a fool’s errand at best.
If life events have forced you to rethink your goals, let’s talk. Financial plans are not set in stone. Yet,
adherence to one’s financial plan and a long-term focus have historically been the straightest path
to reaching one’s goals. We may see volatility this year. However, keep in mind predictions are simply
educated guesses. As we’ve seen in the past, sell-offs when they occur, are followed by rebounds.
Keep this in mind as we navigate the rest of 2022 together.
If you have any questions or would like to discuss anything in this update or any other matter,
please feel free yo give me a call. As always, I’m honored and humbled you have given me the
opportunity to serve you.