Market Review Q222: Breaking Up is Hard to Do

The second quarter capped off a second consecutive quarter of dismal returns for both stocks and balanced (aka 60/40) portfolios. Clearly, Russia's invasion of Ukraine threw commodities markets into a tailspin and re-ignited geopolitical concerns. Clearly, the Fed dramatically reversed course by promising to aggressively tackle inflation.

Unfortunately, it is less clear what investors should do about. Is this the beginning or end of a bear market? Who or what should investors look to for clues?

You and me forever

For thirteen years now, investors have relied on the Fed to show the way. In times of trouble the Fed has softened the blows and made sure everything would be OK again. In good times it watched with pleasure as stocks kept going up – an up.

Not surprisingly, this developed into an unhealthy co-dependence. Investors liked the stunningly easy returns to be made and the Fed liked the attention.

It also created quite a habit. After being conditioned by the Fed to take on risk for so long, not only did investors comply, but also became outright fearful of missing out on the bounty.

Please don’t go

Now, with stocks and bonds down in the first half of the year, inflation a persistent concern, and a notably more ominous tone to markets, investors are looking for guidance. As with matters of the heart, however, emotion often trumps rationality.

The situation was captured well by John Hussman: "Bearish sentiment appears to be dominant among investors, but there is little evidence that investors have actually acted on that sentiment, suggesting that they are operating on hope that 'it [the market] always comes back'."

The Financial Times reported similar sentiments: "But the habit of making bets with the Fed’s safety net below will be hard to break, she [Andrea DiCenso from Loomis Sayles] says. 'People are thinking: ‘I want to get back to QE. How do we get back to the QE'?"

The prospect of investing without the Fed’s backstop is causing consternation – and paralysis. Buying the dip hasn’t worked. Almost everything is harder but doing anything different is hard too. While many investors understand cognitively the Fed has a different agenda today, that cognition has not translated into remedial action.

You go your way and I’ll go mine

How can investors overcome the historical ties? How can they establish a fresh perspective? How can they get enough confidence to change course?

While there is almost always emotional baggage involved in personal relationships, investors’ relationship with the Fed is not nearly so fraught. After all each was using the other and neither one cared. The Fed used investors to propagate risk appetite to boost growth and investors were just in it for the returns.

As a result, it shouldn’t be too hard for investors to revert to what always worked before – doing that old-fashioned stuff like fundamental research and analysis. Quantitative models. Accounting analysis. You know – work.

Greg Jensen from Bridgewater Associates made the case for such work, albeit indirectly, in a recent podcast with Grant Williams. Jensen recounts the challenge last summer of anticipating inflation: "I think it was August of last year [2021], unbelievably given what was going on, the, the ten-year note was at 1.3%".

He says “unbelievably” because demand was booming from stimulus payments, supply was constrained from bottlenecks and labor shortages, a new and different monetary policy regime had been established in which monetary policy supported fiscal spending, and inflation was already coming in hot. Despite the evidence, the Fed dismissed the occurrence as "transitory". The Treasury market just followed the Fed’s assessment as the 10-year yield sported a one-handle.

Suddenly, however, right at the beginning of the year, everything started to change. The 10-year yield started working its way up. It was slow and sporadic at first, but after Russia's invasion of Ukraine, it started jumping up by leaps and bounds. In hindsight, market rates provide to be an unreliable guide. What worked a lot better was an analysis of the data – the clues were there.

Don’t think twice it’s alright

Such disconnects continue to exist today. With stocks down on the order of 20% from the beginning of the year, multiples are starting to look somewhat interesting. Jensen, again, doesn't buy it. He argues, "It [cash flow expectations] hasn’t priced in a real decline in the cash flows, which I think is we’re in it. This is coming and the next six months are going to probably be about the decline in profits."

Hussman also points out the problem with profits and arrives at a similar conclusion. He shows how margins have become "misaligned" with real unit labor costs, as they also did before the global financial crisis. He describes:

When you hear analysts gushing that the “forward P/E ratio” of the S&P 500 has declined to presumably attractive levels, keep in mind that the current forward P/E reflects the highest earnings estimates and profit margins in the history of the U.S. equity market. Even ignoring every prior market cycle, current profit margins are 30-40% above the median observed during the bull market since 2009.

In regard to declining profits Hussman warns, “This shoe hasn’t dropped”. Once again, the data spells trouble but the market isn’t listening.

Go your own way

Yet another place investors can look to for guidance is historical patterns. Those who have been investing for a while or who have studied history (or both) may recognize another pattern that can be helpful in assessing the situation (by Robert Rhea in the Dow Theory):

There are three principal phases of a bear market: the first represents the abandonment of the hopes upon which stocks were purchased at inflated prices; the second reflects selling due to decreased business and earnings, and the third is caused by distress selling of sound securities, regardless of their value, by those who must find a cash market for at least a portion of their assets.

This provides some helpful context. The “abandonment of hopes” has mostly happened since profitless tech stocks, SPACs, many cryptocurrencies, and a host of other assets of dubious investment merit have already been taken out to the woodshed.

In this construct, what Jensen and Hussman describe as the coming decline in profits matches up pretty well with “selling due to decreased business and earnings”. By this reckoning then, we are only about one-third through this bear market.

You’ve lost that loving feeling

At this point, it is interesting to circle back to the Fed in order to reassess its relationship with investors with some fresh perspective. As Joseph Wang notes in a recent Substack post, the Fed just isn’t that into investors anymore.

Further, not only has the Fed changed its focus, but as Wang claims, it now has the tools to stick to the course. According to Wang, “An aggressive tightening will likely lead to cracks in financial markets before inflation is tamed”, but … “the Fed now has the tools to support the real economy and keep tightening until the last ounce of inflation is squeezed out.

Let that sink in for a bit. While theories are being bandied about as to what part of the markets will “break” and when the Fed will need to restart quantitative easing (QE), Wang hypothesizes a very different scenario. He sees a Fed that can, and will, keep tightening the screws while also being able to prevent systemic problems from arising. To the extent this is true, investors will need to recalibrate their understanding or suffer severe consequences.

Conclusion

Market conditions have changed and not surprisingly, investors are looking for some guidance to help navigate the new conditions. Unfortunately, the benign conditions of low rates and a Fed backstop are gone, though investors seem reluctant to acknowledge this and move on.

This presents an extremely unique challenge and opportunity. The challenge for investors is to break their dependence on the Fed. Sure, the relationship worked great for a long time … but now it is clearly not working. In order to move on, investors are going to need to revert to what worked for them in the past.

Namely, it is time to develop better self-reliance. Specifically, it is a great time to learn or become reacquainted with skills like research and analysis and to use those to develop an independent perspective.

Further, because so many other investors are simply following along passively, either still spellbound by the Fed’s QE charms or simply oblivious, there is a significant opportunity to benefit, absolutely but especially relatively, by doing something different. These situations just do not come around very often.

To be sure, given the adverse conditions of an aggressively tightening Fed, there aren’t likely to be a lot of home run opportunities in the near term. However, you don’t have to keep striking out either and it would be nice to have something left to invest when stocks get c

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