The investment landscape is pockmarked by intractable statistics that continue to impose strategic and psychological barriers to the short term potential of portfolio alpha. The realities that inflation, war, unemployment, and social injustice are not “quick-fix” problems have never been more apparent than now, in a post-pandemic global economy.
Given that the Federal Reserve and other central banks have embarked upon a policy of raising interest rates to attack (post-Covid) high demand (inflation) one might wonder whether their goal is to perpetuate economic recovery or to stifle it. Clearly, the events in the banking industry over the last month have cast a long shadow over this course of action. If the economy is truly growing, we are hard pressed to find it but for only a few select sectors, such as energy and technology.
Despite what the Fed calls a “temporary” condition regarding rate hikes, permanence is being built into their model. In fact, one could make the argument that a sustainable, broad recovery is helped by higher interest rates. Inflation and robust demand are definitional to a multi-tiered expansion, signifying full capacity, higher savings rates, discerning borrowing, and lower debt. Not only that, but high interest rates also provide for an investment option other than equities to generate portfolio returns.
Markets
It is no coincidence that our bond allocations have increased significantly during the past year while our cash levels have diminished accordingly. Combine this with the fact that the probability of stocks outperforming bonds has fallen to the lowest level in years. Conversely, the likelihood of bonds outperforming stocks on a total return basis has risen for the first time in two years. All these data stand in sharp contrast to where we were at the beginning of the pandemic. Then, as the economy was in a state of “benign equilibrium”, equities were seemingly the only investment option during a period of near-zero percent interest rates. Today, our relative strength integers (RSI) show stocks to be relatively overvalued but not written off completely.
The fact that bonds remain a compelling value…on a relative basis….is suggestive of a time nearly 40 years ago, the 1980’s. As interest rates began to recede in the decades that followed, stocks generated one of the greatest bull market secular periods in the market’s past. If you’re a fan of history, and you believe that today’s rate increases are unwarranted and unsustainable, then you might be inclined to capitalize upon a fallow stock market for a repeat performance.
With all of these contradictory hypotheses floating around it is no wonder that the economy feels unsteady. Unfortunately, one cannot just sit on the sidelines and wait for an ideal inflection to reveal itself. The pace of change requires us to adapt to many fluid situations, make choices, even if the choice is destined to be modified at a later date. Investing is never about guarantees…it is acting and reacting to the opportunity in front of you. A strong thematic portfolio reduces anxieties for investors, particularly during downturns, because those kinds of investments produce consistent cash flow, more durable profitability, and relative invulnerability to price compressions that usually lessen the value of more cyclical businesses.
It was only a few years ago that we lamented in our commentaries about an excessive upwards “linear” spike in asset valuations. We argued that enthusiasm and euphoria were supplanting hard data when investors grudgingly poured non-risk capital into stocks. As it turns out, some benefitted from taking that risk; many others, however, did not. Conflating “reasonable return” with “reasonable risk” caused many to lose money during a cycle of speculation and volatility if their picks were not the “darlings” of the day. Those linear price spikes were driven by greed and exhilaration. There was a feeling that the good times would never end. That euphoric disingenuousness became the underpinnings of the Covid collapse.
Curiously, the market never seems “ready” for capitulation despite the fact that the laws of physics, economics, and history tell us otherwise. Two years ago, interest rates were near zero; today they are almost 500% higher. If I tried to “sell you that bridge” in 2020, that the markets were hyperbolic and overextended, you would have laughed hysterically. Fighting inflation while maintaining economic recovery is a delicate balance. But consider that we, as investors, have been waiting for growth and opportunity for quite some time. Amongst all the alternatives from which to choose, we consider that generating alpha from something other than just random stock-picking is a good thing. Higher interest rates might be emblematic of higher inflation but growth, after all, is the ultimate end-game and perhaps the “price” we have to pay to earn it.
Strategy
It is important not to confuse these short-term arguments with how one perceives…and acts upon...longer term secular opportunity. For example, bond yields, like stock prices, vacillate over time. Inflation surges, then recedes. Portfolio rates of return modulate from bad to good, then back again. It is not unreasonable, as noted earlier, to expect the best but to prepare for the worst. It’s the nature of portfolio management. Great sports coaches have always preached that winning requires an exceptional defense, first...then a strong offense.
Of all the ironies we see at present is how fundamentals have become less significant to client decision-making. Emotion has unfortunately taken over as a critical replacement for data in the asset selection process. Whatever the methodology, exogenous noise and “tips” from anonymous sources have supplanted discipline and common sense. When valuations rise there is a stampede to ride the wave; when the trend recedes, money looks for the exits and tries to hide. How similar these moments have become to the dot.com era, or the housing-contraction period over a decade ago.
This is not to suggest a complete abrogation by responsible investors. Rather, as expressed on a continuum, the triggers that manifest behavior are decidedly shifting. Sometimes, events of an historical nature change us so significantly that it becomes necessary to redefine our influences. Covid was one such occurrence.
Conclusion
The extent of one’s optimism about the future might owe to one’s status in life or past successes. Things are never as good as they seem nor as bad as one might imagine. Anecdotal tales of surviving the pandemic, or maybe losing a job or a family member, abound and affect not only our life’s decisions but our souls as well. A myriad number of stimuli from a myriad number of sources are causing all of us to take stock of what matters...perhaps even to subdue an urge towards impetuous decision-making going forward.
The huge volatility witnessed at the end of this past quarter was the result of a recoil in stock prices, and consumer confidence, caused by central bank’s interest rate policies. If yields continue to rise, for example, we would expect further attrition of the financial markets...just as we saw in March. These volcanic disturbances will factor heavily in our asset allocation strategies for this quarter and the remainder of the year. For those investors whose portfolios wind up “giving back” all of their hard-won gains it might be attributed to a stubbornness emanating from the disingenuous notion that “everything goes up, all the time”.
Investing is cyclical, we agree. Monetary policymakers have already given strong indication about their intention to maintain an anti-inflationary bias. We should believe them. We also believe, however that there are untapped opportunities in secular, socially responsible themes such as agriculture, climate, energy, water, healthcare, and technology that can be effectively mined for capital gains….and prudent governance… in the years ahead. The spirit of the capital markets is not defined by a 24 hour news cycle. Rather, it is a means to tap into bold crisis solution-making for the good of the future.
Suggested balanced account asset allocation, Q2, 2023
Equity: 48%
Fixed Income: 42%
Cash: 10%
Arlington Econometrics is a quantitative market tool.Utilizing proprietary algorithmic equations, AE offers solutions for market-timing, asset allocation, and macro economic analysis.Using historical time-series measurements, Arlington Econometrics optimizes the analytical process and forecasting coefficients to make economic forecasting more objective.
The information contained herein has been obtained from sources believed to be reliable, but is not necessarily complete and its accuracy cannot be guaranteed. This report is not to be construed as an offer to sell or solicitation to buy any security. It is intended for private information purposes only. Any opinions expressed are subject to change without notice. Alexander Capital and its affiliated companies and/or individuals may from time to time own or have positions in the securities or contrary to the recommendations discussed herein. Neither Alexander Capital, LP nor any of its affiliates (collectively, “Alexander Capital, LP”) is responsible for any recommendation, solicitation, offer or agreement or any information about any transaction, security, customer account, or account activity in this communication.
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