Fed-Up(date)
It has been another tough week in a tough year for both stocks and bonds. The latest drivers of the sell-off were a higher than expected Consumer Price Index report and another hawkish speech from Fed Chair Jerome Powell. The market narrative shifted back to the same one that drove the June lows to combat high inflation the Fed will have to raise interest rates more and that could cause a recession. The market reaction was predictable as bonds and stocks sold off as interest rates surged. At the close today, the markets are currently oversold on several metrics.
Positioning
We remain defensively positioned in Global Vigilance. In fact, we are as defensive in terms of asset allocation in our model portfolio as we have ever been with just 42.5% invested in equities and 16.5% in cash. We have continued to take risk down and have focused on reducing exposure to those stocks most sensitive to the economy and high interest rates to further protect capital. Capital preservation is foremost on our minds.
Good News
This bond sell-off has provided a silver lining: yield. The 2 Year treasury now yields 4.2% and the Bloomberg US Corporate Bond Index representing Investment Grade companies yields 5.4%. Yields have not been this high since 2007. We have added exposure specifically in these areas. We may add even more exposure to fixed income should it become evident that interest rate volatility begins to ebb.
Playbook
We remain defensive until two things happen. First, interest rates need to stop rising. As we have discussed on our Monthly Strategy calls, the market is ahead of the Fed. This week the Fed raised interest rates a further 75bps to 3.25% and offered projections that imply at peak policy rate of approximately 4.5% by year end[1]. The market via the Fed Funds futures has priced in a peak rate of approximately 4.75% by March 2023. This in no way means that interest rates will not climb even higher, however, included in the Fed’s projections is a year-end forecast of 4.5% Core PCE, which represents the price index for personal consumption expenditures excluding food and energy (the Fed’s favorite inflation metric). Core PCE in July fell to 4.56% and given its declining trajectory begins to beg the question if we are witnessing peak interest rates. Were this to occur, we believe high quality fixed income becomes quite attractive.
Jobs Jobs Jobs
Once interest rates stabilize the market’s attention will be laser-focused on the possibility of a recession. We detailed in our Monthly Strategy presentations numerous examples of deceleration across the economy and, particularly, in the Durable Goods part of the economy. But what has yet to crack is the labor market and that has propped up consumer spending to a large degree. We do expect some increase in the unemployment rate but there is a great deal of uncertainty in predicting it and what the ensuing effect will be on consumer spending. It is this uncertainty that is likely to continue to weigh on equities. The market will tend to price in a recession prior to its occurrence and even bottom well before the economy.
Earnings Estimates
Linked to this economic uncertainty is the unpredictability of earnings estimates, which have only declined slightly. The third quarter earnings season is less than a month away and this could be the catalyst for forecasts to be reduced. The market often anticipates earnings estimate cuts which can be seen through forward price-to-earnings (PE) multiple compression. The S&P 500’s forward PE, for example, has compressed from a high of 21.5x last November to 15.5x today. As we have discussed previously, there is no magic floor to the market PE but unless some form of a crisis emerges – which is nearly impossible to predict – the S&P 500 has typically bottomed at 14x prior to significant downward forward earnings revisions, according to our analysis. Empirically, this would suggest that we are getting close to a market bottom, but it also means the S&P 500 could decline a further 10% from current levels. That would put the index down approximately -35% from the peak.
Conclusion: Opportunity
Remember the old adage: “Buy Low Sell High”? The fundamental mission of Global Vigilance is to change the risk in the portfolio depending on the market environment. So, in cases of declining markets like today, the goal is to protect capital so the strategy declines less than the market and then buy back at better risk-adjusted prices. We believe that achieving this objective plays a critical role in long-term wealth creation. That is to say that we welcome market declines in the short-term to help us achieve long-term goals. History is riddled with examples of market sell-offs or what we like to call opportunities. At some point, as indicated above, it will be time to begin taking advantage of this current opportunity.
Disclosures
LIM is a Registered Investment Advisor based in Dallas, Texas and registered with the Securities and Exchange Commission. Registration does not imply a certain level of skills or training. LIM is a company with purpose, dedicated to creative and unique thinking. We focus on portfolio valuation and research, along with a superior client experience. We seek to identify investment opportunities by looking at economic factors, security valuation and human behavior. We start with the fundamentals of portfolio management and valuation. Then we build on these fundamentals with unique thinking and creative intelligence gathering to form a viable investment thesis. We believe this approach leads to dynamic global portfolios with increased return and managed risk. LIM utilizes Charles Schwab & Co. Inc. (“Schwab”), a FINRA-registered broker-dealer, member SIPC, as its custodian of assets. LIM is independently owned and operated and not affiliated with Schwab.
Additional disclosures:
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Investing in alternative assets involves higher risks than traditional investments and is suitable only for sophisticated investors. Alternative investments involve greater risks than traditional investments and should not be deemed a complete investment program. They are not tax efficient and an investor should consult with his/her tax advisor prior to investing. Alternative investments have higher fees than traditional investments and they may also be highly leveraged and engage in speculative investment techniques, which can magnify the potential for investment loss or gain. The value of the investment may fall as well as rise and investors may get back less than they invested.
Bonds are subject to interest rate risks. Bond prices generally fall when interest rates rise.
Investment in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates, or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.
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Data Sources: BlackDiamond, Bloomberg, Lear Investment Management and various other sources as cited herein.
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Definitions
The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value weighted index (stock price times number of shares outstanding), with each stock’s weight in the Index proportionate to it market value.
The Nasdaq Composite Index is a market cap-weighted index, representing the value of all stocks listed on the Nasdaq Stock Market. The composition of the Nasdaq Composite is a mix of long-established companies that have been on the exchange since inception, to IPO newcomers, companies that grew from OTC exchanges or switched from other exchanges.
The Dow Jones Industrial Average is a price-weighted average of 30 blue-chip stocks that are generally the leaders in their industry. It has been a widely followed indicator of the stock market since October 1, 1928.
U.S. Treasury securities are guaranteed as to the timely payment of principal and interest if held to maturity. Investment options are neither issued nor guaranteed by the U.S. government.
The Bloomberg Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.
The Bloomberg U.S. Investment Grade Corporate Bond Index covers U.S. dollar denominated, investment-grade, fixed ratee or step up, taxable securities sold by industrial, utility and financial issuers. It includes publicly issued U.S. corporate and foreign debentures and secured notes that meet specified maturity, liquidity and quality requirements. Securities included in the index must have at lease 1 year until final maturity and be rated investment-grade (Baa3/BBB-/BBB+) or better using the middle rating of Moody’s, S&P, and Fitch.
The Bloomberg US High Yield Index covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below. A small number of unrated bonds are included in the index. The index excludes emerging markets debt.
Bloomberg Commodity Index is comprised of futures contracts and is designed to be a highly liquid and diversified benchmark for commodity as an asset class.