Saturday, June 25, 2022

Market and Economic Update

Equity markets staged a relief rally this week on encouraging signs that inflation and consumers' expectations for future inflation may have peaked. Prices of commodities such as lumber and copper have turned lower, suggesting inflationary pressures could be decreasing. The University of Michigan's Consumer Sentiment Survey for the end of June showed a slight decrease in consumers' expectations for future inflation. http://www.sca.isr.umich.edu/files/chpx1r.pdf  If these trends continue, the Federal Reserve may not need to raise interest rates as aggressively.

Everything comes down to the Federal Reserve's monetary policy. Tighter monetary policy slows economic growth, leading to lower corporate earnings and stock prices.

  • COVID-19 interrupting supply chains from China leads to inventory constraints, higher prices, higher inflation, and the Fed tightens monetary policy.
  • The war in Ukraine leads to reduced production of grains and other raw materials, which leads to food shortages, higher food prices, higher inflation, and the Fed tightens monetary policy.
  • Sanctions and bans on Russian oil & gas lead to supply shortages, higher energy prices, higher inflation, and the Fed tightens monetary policy.
  • When the labor market is too tight, employees have more bargaining power, increasing competition for workers. Higher wages are passed on to consumers through higher prices for goods and services. Prices rising too quickly leads to higher inflation, and the Fed tightens monetary policy.

Inflationary news will tend to move equity markets lower, and information suggesting inflation may have peaked or could move lower will support higher equity prices.


I am cautiously optimistic that markets will end the year higher than current levels. Still, I would feel better hearing that the Fed sees enough evidence of inflation moving towards its target and that monetary policy will become less aggressive. The Federal Reserve meets again on July 26th and 27th, when they are expected to raise interest rates by .5% to .75%. There is no meeting in August, and inflation may have peaked and begun rolling over by their September meeting. As we move through the Summer, there will be an increased focus on the mid-term elections.


When Americans become pessimistic and frustrated, there is a tendency to blame politicians, and leadership change often follows. The 2008 recession began under a Republican administration, ushering in a Democrat President and super majority in Congress. Americans became frustrated with the legislative agenda, and in the 2010 mid-term election, the Democrats took a "shellacking," as described by President Obama. The pendulum swung towards Republicans in 2016 and Democrats in 2020. I give this history lesson to say that as we approach the 2022 mid-term election, the odds are increasing that there could be a shift in the balance of power in Congress. When leadership changes in Washington in either direction, a hope can form that a positive change in the country's direction may follow. Secondly, a divided government can be good for markets as there is a reduced possibility of significant legislative changes allowing companies to plan better.


Outlook – My view hasn't changed. There is a risk that we are in or on the cusp of a recession. The Federal Reserve does not have a good track record of raising interest rates without causing a recession. Given the labor market's strength, a recession would probably be short, mild, and more of a technical event. It is just as likely that the economy will slow enough to bring down inflation, and a recession will be avoided. Elevated market volatility should be expected, meaning sharp moves down and up. Market sell-offs should not be interpreted as the end of life as we know it, nor should rallies be a reason for euphoric celebration. The economy and markets are going through a transition; it will be messy and take some time. We've been through transitions before.


This would be an excellent time to review your spending plans. If you receive monthly distributions from investment accounts that are recalculated annually, your 2023 distribution amount could be less. I hope you found this helpful. I will continue to monitor markets and the economy and keep you informed.

Sunday, June 5, 2022

Recession Watch #4 - CEO's Urge Caution

In February, I began sharing that the risks of a recession were rising; those risks continue to increase, but there are reasons for optimism. In addition to hard economic data, I also consider qualitative data, which can be the opinions of subject matter experts or people in a position to have additional information. This week several Fed officials shared their views on the future path of interest rates. Several business leaders expressed concerns about the economy; those opinions should be weighed along with the market and economic data in forming an investment thesis.

Qualitative Data
Monday – Speaking at the Institute for Monetary and Financial Stability in Frankfurt, Germany, Federal Reserve Governor Christopher Waller said he's in favor of several additional half percent or fifty basis point increases in the Fed Funds rate until he sees "inflation coming down closer to our 2 percent target."

Wednesday - Speaking at a conference, JPMorgan Chase CEO Jamie Dimon said, "It's a hurricane. Right now, it's kind of sunny; things are doing fine; everyone thinks the Fed can handle this." "That hurricane is right out there, down the road, coming our way," he added. "We just don't know if it's a minor one or Superstorm Sandy or Andrew or something like that. You better brace yourself." In earlier comments, Dimon had characterized his concerns as storm clouds on the horizon. Those storm clouds have now developed into a hurricane watch.

Thursday - Speaking at a conference, Goldman Sachs President John Waldron said, "This is among — if not the most — complex, dynamic environments I've ever seen in my career." "The confluence of the number of shocks to the system to me is unprecedented."

Friday – In an internal email, Tesla CEO Elon Musk directed executives to pause hiring worldwide and said that 10% of salaried positions would be cut while hourly headcount would increase. Musk added that he has a "super bad feeling" about the economy. Musk later clarified that he expected the total number employed by Tesla to increase.

In an interview with CNBC, Cleveland Federal Reserve Bank President Loretta Mester said; "My starting point will be, do we need to do another 50, or not, have I seen compelling evidence that inflation is on that downward trajectory, then maybe we can go to 25" basis points, she said. "I'm not in the camp that thinks we need to stop in September." Many had expected the Federal Reserve to hike rates by a half percent two more times before pausing in September.

Quantitative Data
Tuesday - The Case-Shiller National Home Price Index showed a year-over-year change in home prices of 20.54%. I do not expect home prices will continue rising at this pace, nor do I expect home prices to fall dramatically. The pandemic caused a change in how people think about where they live and how they work. There are regional supply/demand imbalances that will continue.

Wednesday - The Federal Reserve Bank of New York lowered its 12-month recession probability to 3.71%. I don't put a lot of stock in the predictive ability of this indicator but that it is trending downward is encouraging.
The Bureau of Labor Statistics reported 11.4M non-farm job openings in the US. 

Thursday – The Department of Labor reported that initial weekly claims for unemployment insurance were 200K, down 50% from a year ago. Employment is a lagging economic indicator, and unemployment claims tend to rise during a recession. It is difficult to argue that we are currently in a recession, with unemployment claims at a 50-year low. 

Friday – The Bureau of Labor Statistics reported US Nonfarm Payrolls grew by 390K in May. The unemployment rate remained steady at 3.6%, payrolls grew as additional people returned to the workforce, and the Labor Force Participation Rate rose to 62.30%. There is a total of 5.95M unemployed people in the US.

Other Considerations
Several companies have lowered their earnings estimates but have primarily cited currency exchange risks from overseas operations due to the stronger dollar.
Despite the headwinds, few analysts have reduced their earnings estimates for the S&P 500.

Summary
Market participants are focused on things that feed into inflation and how it shapes the Federal Reserves' interest rate policy in response.
  • The war in Ukraine is a human tragedy; the resulting impact on global fuel and food supplies is inflationary.
  • Continued disruptions to supply chains related to COVID-19 are inflationary.
  • Increased post-pandemic consumer activity is inflationary.
  • The tight labor market is causing some wage inflation which is passed to consumers as higher prices. Employers have openings for 11.4M more employees while only 5.95M people are unemployed. The economy will need to slow to the point of job destruction to bring the labor market into balance.
There is evidence that tightening monetary conditions is slowing economic growth. The concern is that, as has happened in the past, to get inflation under control, Fed policy will have to become restrictive to the point of causing a recession. Given the level of uncertainty, the stated path of Fed policy, and statements from business leaders, continued defensive positioning in portfolio models is warranted.
  • When people hear the word recession, their minds go back to previous deep recessionary periods when they may have experienced financial hardship. I do not see a recession forming in 2022. The US economy is a big ship to turn, and with a tight labor market, an economic contraction would be difficult. People who are employed get a regular paycheck that they spend buying goods and services, which drives the economy. Right now, the Fed is in the driver's seat. We're waiting to see if they can slow to the speed limit or if they are going to slam on the brakes and send the economy through the windshield. A recession within the next two years may be unavoidable but it's not imminent.
  • I expected increased volatility during the first half of the year as market participants adjusted to changes in Fed policy. The war in Ukraine and the unexpected COVID-19-related lockdowns in China have added to the market volatility. With the coming mid-term elections, I expect elevated levels of volatility to continue into the Fall.
  • My reasonable range for the S&P 500 is to trade between 4000 and 5000 for the remainder of the year, ending with a positive or negative single-digit return.
I encourage you to avoid thinking in binary terms. There is a tendency to believe that the current trend will continue into eternity. When markets are rising, many think they will continue going up even in the face of data to the contrary. When markets decline, some feel that nothing good can ever happen again. Wars eventually end, supply chains will normalize, and inflation will moderate. I believe the best strategy is not to be in or out of markets but rather to adjust based on your goals, time horizon, and current risks.

Sunday, May 29, 2022

Could last Week’s Rally be a Head-Fake?

A Head-Fake?

The S&P 500 broke its seven-week losing streak last week with a solid multi-day rally of more than 6%. In recent years, we've become accustomed to market corrections followed by rallies to new highs. Last week's rally could be the beginning of stabilization in equity markets, but it could also be a head fake. There are no rules, but market corrections of greater than 10% are often resolved by a capitulation day; when 90% of stocks close lower, and the volatility index peaks above 36. It will seem like all hope is lost on that day and that nothing good will ever happen again. We haven't had a day like that yet. Analysts have suggested that markets could retest the 3800 level or lower before stabilizing later in the year. Market corrections can also end with the resolution of the issues that caused markets to correct. Before we can move to new highs, I expect we will need to see progress toward a solution to the war in Ukraine, evidence that supply chains are normalizing, and a statement from the Federal Reserve that inflation is improving, and and indication that their policy may be less restrictive going forward.

 

Hot Economy, Inflation, and Recession

It may seem counterintuitive because we want economic activity and growth, but the economy is running too hot, causing inflation. The Federal Reserve is shifting to a more restrictive monetary policy to combat inflation and slow the economy. Before markets can move higher, we need to see evidence that the Feds policy is working and the economy is coming into balance. When the Fed has tightened monetary policy in most past cycles, the economy has slowed, stalled, and contracted into a recession, making a recession probable but not imminent. I am not expecting a recession like we saw in 2001 or 2008. There is a tendency to prepare ourselves mentally to fight the last recession. It's important to know that recessions aren't bad; they are part of the economic cycle and correct excesses and dislocations in the economy. The Dot Com bubble bursting in 2001 was caused by excessive speculation in technology companies that had little revenue or earnings. The technology sector is now one of the more profitable areas of our economy. The Great Financial Crisis resulted from speculation in the housing market, questionable mortgage investment vehicles, and an overextended consumer. Since then, regulations have strengthened the financial system; there is more need for housing than supply, and consumer and corporate balance sheets are relatively good. It is unlikely that the next recession, whenever it comes, will look like previous recessions.

 

The Labor Market and Inflation

Because the unemployment rate is unusually low, employees have more bargaining power than they have had in a long time. Higher wages are an expense to the employer that gets passed on to the consumer through higher prices. Unlike supply-related inflation, which can be moderated by increasing supply, wage inflation is sticky. Once employees' wages are set higher, it is difficult for prices to fall as those higher wages would need to be cut. We need the gap between job openings and the number of unemployed people to shrink to slow inflation. The unemployment rate rising to 5% would reduce inflationary pressures, but that is unlikely in the near term.

 

Economic Reports

Monday – The Energy Department's Retail Gas Price Report showed the national average for a gallon of gasoline was $4.69, up from $4.59 the week before and 50% higher than one year ago. With China scheduled to begin some reopening in early June, increased air travel, and the summer driving season, I expect gas prices to rise until they reach some level of demand destruction.

 

Tuesday – The Census Bureau reported Sales of New Single-Family Homes were down 16.64% in April, the fourth consecutive month of slower sales, as rising home prices and rising interest rates are slowing demand. Real estate in some markets is beginning to come into a balance between the number of buyers and sellers.

At this point, a slowdown in new home sales is a good thing and part of why markets rallied last week. The housing market has been too hot, and rising home prices have contributed to inflation.

 

Wednesday – The Commerce Department reported a month-over-month rise in New orders for Durable Goods of 0.44%, suggesting moderate economic growth.

 

Thursday – The Labor Department released the weekly number of Initial Claims for Unemployment Insurance - 210K vs. 218K the previous week. We've seen some rise in claims from historically low levels but not enough to indicate a change in how tight the labor market is.

Freddie Mac's Primary Mortgage Market Survey® - The average 30 Year Fixed Mortgage Rate is 5.25%, compared to 5.30% last week and 2.94% a year ago.

 

Friday - The Bureau of Economic Analysis released the Core PCE report (Personal Consumption Expenditures). This is the Federal Reserve's preferred measure of inflation and is the inflation rate with food and energy stripped out. They remove food and energy because those tend to be more volatile over shorter periods and can distort inflation data. Year over year, this measure of inflation was 4.91%, compared to 5.20% last month and 5.30% the month before.

Lower inflation data was a catalyst for the market moving higher Friday. If inflation falls, the Fed will have less work to slow the economy.

 

Next Week

Tuesday - We'll get the Case-Shiller Home Price Index which will inform our view on inflation.

Wednesday – The Institute for Supply Management will release their Purchasing Managers Index, giving us insight into the manufacturing sector.

The Federal Reserve Bank of New York will update its 12-month recession probability report. Last month's recession probability was 5.49%, well below the longer-term average.

Thursday – We'll get ADP Nonfarm Payrolls, Weekly unemployment claims, and the Bureau of Labor Statistics quarterly productivity report. All will be closely watched.

Friday – The Bureau of Labor Statistics monthly jobs report. I would prefer to see a weaker report, suggesting the economy may be slowing on its own. Though some are calling for the Fed to be more aggressive, I would be happy for them to move slowly and not break anything.

 

There are some minor signs of improvement in supply chains and inflation, but it is too early to know how meaningful. I believe the Fed will remain on its current course and raise interest rates by 0.5% at their June and July meetings. I think markets will continue to be volatile, but we could see some moderation and higher levels later this year. I do not believe we will see a recession in 2022, but we should not be surprised by a mild recession in 2023. This is not based on any current economic data but rather on the Federal Reserve's poor record at navigating rising rates.

Sunday, May 15, 2022

Economic and Market Update

 The Economy


Consumer Sentiment - The Index of Consumer Sentiment, provided by the University of Michigan, tracks consumer sentiment in the US based on surveys of random samples of US households. The most recent data was released Friday. The current level of 59.10 decreased from 65.20 last month and from 82.90 one year ago, and the lowest level since 2011. This data, though not conclusive, would suggest we may be in a recession now. Consumer sentiment typically bottoms at the trough of a recession when consumers are under the most stress.

 

Inflation - The Consumer Price Index (CPI) is at 8.26%, down from 8.54% last month and 4.16% a year ago. The long-term average is 3.25%. Some believe that inflation may have already peaked and will begin declining. Here's the thing to know. The inflation rate is the rate of change, not the level of prices. Even though the inflation rate may fall, prices may remain elevated, just not rise at the same rate. Some of the inflation is now coming from increasing wages. For example, the supply of chickens may normalize, but the salaries paid to process the chickens are sticky. It is difficult to cut an employee's wages once raised.

 

Employment - The Unemployment Rate is unchanged from the previous month at 3.60%, down from 6.00% a year ago. The long-term average is 5.75%. The Job Openings and Labor Turnover Survey compared to the number of unemployed persons shows there are 1.9 job openings for every unemployed person. It would be difficult to have a deep recession with below-average unemployment. Unfilled jobs need to be reduced, and the unemployment rate may need to rise to get inflation under control. 

 

GDP – First quarter Gross Domestic Product (GDP) was -1.4%, following +6.9% in the fourth quarter of 2021. It is often cited that a recession begins with two consecutive quarters of negative GDP, of which this could be the first. The biggest detractor from first-quarter GDP was a drop in exports; it could be that the first-quarter surge in Omicron impacted GDP.

 

Recession – The economy is constantly expanding and contracting. A recession is an extended period of economic contraction usually characterized by high unemployment and declining equity prices. The New York Federal Reserve publishes the Probability of US Recession in the coming 12 months, and the current probability is 3.71%.

https://www.newyorkfed.org/medialibrary/media/research/capital_markets/Prob_Rec.pdf

 

I do not see a recession developing in 2022. The US economy is a big ship to turn, and there are reasons to believe that a recession may not materialize. However, when the Federal Reserve raised interest rates in the past, it often resulted in a recession and makes a 2023 or 2024 recession more likely. In an interview with NPR Thursday, Federal Reserve Chairman Jerome Powell warned that he could not promise a soft landing, meaning getting inflation back to the Fed's 2% target while maintaining full employment may not be possible. The Fed may need to raise interest rates to the point that the economy slows enough to eliminate the current job surplus and cause some layoffs to get inflation under control. The stock market is a leading economic indicator suggesting that the recent market volatility may be market participants repricing what they are willing to pay for stocks in a period of slower economic growth.

 

Equity Markets


Markets remain volatile as market participants adjust to higher interest rates and a less accommodative Federal Reserve. Adding to the uncertainties are the war in Ukraine and the ongoing COVID-19 lockdowns in China. The world's second-largest wheat producer, India, has now banned wheat exports following lower than expected crop yields due to drought. Their food security was cited as the reason. Wheat prices on the global market have been rising, and banning exports may lower the domestic price in India while creating further shortages elsewhere. It was expected that India would be able to make up for some of the lost Ukrainian supply. There will be food shortages in parts of Asia and Africa. It's difficult to discuss the economic impact of war, pandemics, and potential famine without sounding insensitive. Our thoughts and prayers continue to go out to the people affected. I expected markets would be volatile in the first half of the year due to Fed policy changes. The geopolitical issues and the relentless pandemic further complicate market outlooks.

 

Earnings – Stock prices are a function of earnings. So far, 454 companies in the S&P 500 have reported their first-quarter earnings; most are beating estimates. Next week we get the Retail Sales report and earnings reports from Walmart, Target, Home Depot, and Lowes. These reports should give us a good indication of consumer spending, but consumers may have shifted from buying things to doing things.

 

Market levels – The level of the S&P 500 comprises two components. The first is earnings estimates. These are estimates of future earnings provided by companies to their shareholders and analysts who study and follow the companies. 2022 earnings estimates for the S&P 500 range from $210 to $245; let's use the average of $227.50. The second component is the earnings multiple. The earnings multiple is a value assigned by investors that reflects investors' confidence in the future earnings estimates in relation to the potential return on investment alternatives like bonds. It's how we think of the market as cheap or expensive when considering expected earnings. In recent years the multiples have ranged from 18 to 23. Pre-pandemic, we were trading at 19 times forward estimated earnings. Over the past 25 years, the average earnings multiple has been around 16. What we've seen so far this year is not necessarily economic weakness but instead falling confidence and multiple compression. Just as consumer confidence is falling, so is investor confidence. Investors believe that the Fed will raise interest rates and slow economic growth, so they have lowered the multiple they are willing to pay for the estimated growth. So far, most first-quarter corporate earnings have beat estimates, and analysts have not reduced their expectations for future earnings, they may in the future, but for now, we have to work with the data we have.

 

01/03/22 - S&P 500 4796 = $227.50 x 21.08

02/28/22 - S&P 500 4373 = $227.50 x 19.22

04/29/22 - S&P 500 4131 = $227.50 x 18.15

05/12/22 - S&P 500 3930 = $227.50 x 17.27

??/??/??  - S&P 500 3640 = $227.50 x 16.00

 

What makes being underinvested ill-advised is that there is so much negativity being priced into markets that markets could rise quickly if anything good happens. Suppose there was good news on the war in Ukraine or fewer lockdowns in China. What if we see supply chain improvement and lower inflation? These could cause market participants to begin multiple expansions or cause earnings estimates to rise, and the S&P 500 could also quickly rise.

 

If inflation persists, we want exposure to investments in areas where companies can pass on higher prices to consumers. That would be things like Energy and Consumer Staples. If we enter a recession, we want to be overweight areas that do better later in the business cycle, including Energy, Utilities, Healthcare, and Consumer Staples. I've added exposure to these sectors in the portfolio models. A recession is the shortest phase of the business cycle. Equity markets rise and fall in anticipation of what's coming next, meaning that equity markets may rise in the depths of a recession in anticipation of future economic growth. The economy and markets are always changing. I will continue to monitor the data and keep our clients informed.




Saturday, April 16, 2022

It’s different this time!

The four most dangerous words in finance and economics are “it’s different this time.” It’s not; it never is, though there are always those who want to force a set of facts to fit their outlook.  

I often look to history as a guide to what might happen next. And yet we find ourselves at a unique time in history. We are emerging from a global pandemic; there is an active war in Europe, inflation is at multidecade highs, and the Federal Reserve is raising interest rates when the economy shows signs of slowing. Parts of the bond yield curve have inverted, there are recession fears, and yet companies have more job openings than we have people. We have experienced all these conditions at times in the past and can glean insight from what happened next, but we’ve never had a time when all these conditions coincided.

Part of what makes finance and economics so interesting is that it sits at the intersection of the unyielding constant of mathematics and the predictable unpredictability of people. Mark Twain said, “The past does not repeat itself, but it rhymes.” So, where can we find the rhymes?

We are headed for a recession! That sounds scary, but the reality is that we are always headed towards a recession. The economy naturally expands and contracts. We want to know where we are in that cycle and the financial impact of the next contraction. Previous recessions have been preceded by an inversion of the bond yield curve. We saw a short-lived inversion of the yield between the two-year Treasury and the ten-year Treasury, which has preceded some recessions by six to twenty-four months. We are now watching the spread between the three-month Treasury and the ten-year Treasury for confirmation of an inverted yield curve. This inversion has not yet happened and is now showing signs of steepening. If this part of the yield curve inverts, I would expect a recession is on the horizon. I see the risks of a recession in 2022 as low. The low unemployment rate means that people have the income to spend on goods and services in the economy. It would be difficult to experience a significant contraction during a period of such low unemployment. We also need to remember that many of those employed contribute to an employer-sponsored retirement plan. Every month we see inflows to markets from payroll deferrals.

I’ve shared that I thought the first half of the year would be more volatile than the second half. Increased volatility should be expected when the Federal Reserve changes monetary policy. The war in Ukraine adds to the economic uncertainty and may extend the period of volatility, and we’ve yet to see the impact of the mid-term elections.

I expect the S&P 500 to trade between 4000 and 5000 for the remainder of the year. The most pessimistic analyst I follow is Morgan Stanley which expects the S&P 500 to finish the year at 4400. Morgan Stanley Chief Markets Strategist Mike Wilson warned of a market downturn for some time; his 2021 forecast was for the S&P 500 to end 2021 at 4000, which was incorrect. One of the most optimistic analysts I follow is Brian Belski, BMO Capital Markets investment strategist, who sees the S&P 500 finishing the year at 5300. His 2021 target was 4800. The S&P 500 finished 2021 at 4766. Brian Belski was almost spot on with his outlook for 2021; perhaps he will be for 2022.

Summary: I do not see a recession in 2022. There will be increased volatility as market participants contemplate all the economic variables. I am not aware of any market analysts predicting the S&P 500 will finish the year lower than where it is now. The average of the most pessimistic and most optimistic S&P 500 targets would have the S&P 500 gaining 10% from current levels finishing the year with a small gain. I am never anchored to an outlook or opinion, and if the facts and data change, I will adjust my view.

Wednesday, April 6, 2022

Recency Bias

A powerful bias in investing is Recency Bias. Recency bias is the tendency to think that things that have happened recently are more likely to happen again or that a current trend will continue despite data and information to the contrary. Recency Bias can show up in many areas of our lives. People who have been in a serious automobile accident may drive more cautiously for a time. Someone who had a winning lottery ticket may be more inclined to buy more lottery tickets. Recency bias can be based on life experiences and our emotions. Following news of an airplane crash, some will choose not to fly despite evidence that flying is the safest form of transportation. People may be apprehensive about going into the ocean if a shark attack has recently occurred, even if the attack occurred hundreds of miles away. As time passes, if there are no more airplane crashes or shark attacks, the emotions and effects of recency bias fade.

Investors often underperform their investment benchmarks due to Recency Bias. During a bull market, investors may ignore data that suggests they should reduce their equity exposure, preferring to believe that the current upward trend will continue. Investors may also ignore positive economic data during periods of market weakness out of fear that the recent downward trend will continue. The best time to reduce equity exposure would be when markets are at highs, but that doesn’t feel comfortable. The best time to reengage with equity markets would be when markets are at their lows, but that won’t feel comfortable either. The SEC disclosure “Past performance is no guarantee of future results” cautions investors against relying on Recency Bias. Experience has taught me not to try to guess about market highs or lows and to pay more attention to the data and less to my feelings and hunches.

Recency Bias can affect our decisions even when events aren’t so recent. When made aware of a coming hurricane, people who live in the affected areas may choose to evacuate or not evacuate based on their experience with previous storms when they should evaluate the risks of the current storm based on the available data and information. When recession and inflation are in the news, people reflect on their most recent experiences during earlier times of recession and inflation though the economic fundamentals and ultimate outcomes may differ.

We can’t eliminate biases from our decision-making processes, but being aware of them and considering how much weight to give them will help us make better life and investment decisions.

Saturday, February 5, 2022

A Recession Indicator

At the beginning of the pandemic, our portfolio models were more conservatively positioned than they typically would be. I do not have a crystal ball and could not have predicted a global pandemic, but the bond yield curve inverted on August 26, 2019, signaling an increased risk of recession in the coming year. In response to the weakening economic conditions, I reduced portfolio risk and wrote several client emails outlining the concerns and the steps I was taking. Already being on Recession Watch, I probably reacted more quickly to the new health risk than I would have during other periods of the economic cycle.

  • We probably would have entered a recession in 2020 or 2021 even if the pandemic hadn't happened.

One of the most reliable indicators of a coming recession is an inversion of the bond yield curve as measured by the relationship between the yield on the Ten-Year and Two-Year Treasury Notes. Since 1955 an inversion of the yield curve has preceded all US recessions by 6 to 24 months. We are seeing some signs that the yield curve is flattening. Actions by the Federal Reserve and economic uncertainties could lead to a yield curve inversion and a subsequent recession. If this occurred, I estimate a recession would be a 2023 or 2024 event. There is nothing to do now but be aware of it and watch the data.

So, what does it mean to invert the yield curve? If we compare mortgage terms, we expect that the longer the mortgage term, the higher the interest rate should be. We expect to pay a higher rate for a 30-year mortgage than a 15-year mortgage. Likewise, investors expect to receive a greater yield on a ten-year investment than a two-year investment such as Treasury Notes. An inversion of the yield curve occurs when the current yield on the longer-term Ten-Year Treasury Note is less than the yield on the shorter-term Two-Year Treasury Note.

Two forces can work independently or together to cause a yield curve inversion. The first force is the Federal Reserve. The economy can accelerate too rapidly during an economic expansion and create inflation. The Federal Reserve may use monetary policy to curb inflation by raising short-term interest rates, causing shorter-term bond yields to rise. An inversion may occur if yields on longer-term bonds don't rise at the same rate.

The second force is investors. During periods of economic uncertainty, investors may choose to reduce their portfolio risk by increasing their allocation to fixed-income investments like bonds. A general allocation to intermediate-term bonds will include Ten-Year Treasury Notes. As demand for Ten-Year Treasury Notes rises, the yield on these bonds begins to fall. An inversion may occur if the Federal Reserve doesn't respond quickly enough to falling intermediate-term bond yields by lowering short-term interest rates or otherwise making monetary policy more accommodative.

The long-term average yield spread between the ten-year Treasury Note and the two-year Treasury Note is 0.93%. As of February 5, 2022, the spread is 0.62%, below the longer-term average but not yet close to inversion. 

Most conditions that lead to a recession and significant equity market drawdowns develop over time. The US economy is like a big ship, and it doesn't turn quickly. Wars and global pandemics that bring the global economy to a sudden stop would be exceptions. Suppose the yield curve inverts or the economy weakens significantly. In that case, I will move to a more neutral position, understanding that more conservative allocations might be appropriate within six to twelve months. The strategy remains the same. Watch the economic and market data and adjust portfolios as necessary.


Friday, November 26, 2021

Investment Objective and Risk Tolerance

Your Investment Objective is a guideline you have chosen to define your goals and help identify your risk tolerance. Risk tolerance is the level of risk of loss you're willing and able to tolerate while pursuing these goals. All investments involve some amount of risk, including the potential for the loss of principal. Generally, equities (stock-like investments) involve more risk than fixed income (bond-like investments). Equities may have the potential for higher returns but also have the potential for greater losses. The higher your risk tolerance and the longer your time horizon, the more you may want to invest in higher-risk investments. Your investment objective is a factor to help define the ratio of equities and fixed income in your account. Increasing the percentage of fixed income may reduce volatility but may also reduce your potential return.


Reducing your exposure to equities and volatility may also reduce the probability of meeting your investment goals. Currently, interest rates are historically low, and returns on fixed income are correspondingly low. Rising inflation erodes the buying power of money, making fixed-income investments even less attractive. Equities in your portfolio may serve as a hedge against inflation. If you think prices will increase, owning equity in companies raising their prices may help offset the impact of inflation.


Your investment objective can usually be found on the first page of your investment account statement. The approach I recommend is to choose an investment objective that strikes a balance between taking enough risk to realistically pursue your financial goals while also allowing you to sleep well at night. Consideration should be given to how well you're prepared to reach your financial goals.


I do not try to time or jump in and out of investment markets. I choose investments I believe may do well in the intermediate to long-term based on economic and market data, adjusting equity exposure to align with a client's investment objective. Moving towards periods of economic weakness, I may adjust equity exposure towards the lower end of the equity range. Moving into periods of economic strength, I may shift the level of equity exposure to the upper end of the range for a specific investment objective. Below are the investment objectives we use for our clients. Investors should regularly review their investment objectives to maintain alignment with their current financial goals and risk tolerance.


Aggressive Growth – Typically 90% to 100% in equities, 0% to 10% in cash and fixed income.

Emphasis is placed on the potential for aggressive growth and maximum capital appreciation. This objective is considered to have the highest level of risk and is for investors with a longer time horizon.

For retirement planning purposes, this is generally appropriate for people with more than ten years until retirement and a higher tolerance for risk. An aggressive growth investment objective may also be suitable for those whose retirement assets are below target. 


Growth – Typically 70% to 90% in equities, 10% to 30% in cash and fixed income.

Emphasis is placed on achieving long-term growth and capital appreciation. This objective is considered to have a moderate level of risk and is for investors with a longer time horizon.

For retirement planning purposes, this is generally appropriate for people not yet retired who have a moderate tolerance for risk. A growth investment objective may also be suitable for those whose retirement assets are below target.


Growth with Income – Typically 50% to 70% in equities, 30% to 50% in cash and fixed income.

Emphasis is placed on modest capital growth. Certain assets are included to generate income and help reduce overall volatility. This objective is considered to have a moderate level of risk.

For retirement planning purposes, this is appropriate for investors in retirement who have a moderate tolerance for risk and whose retirement assets are on target.


Income with Moderate Growth – Typically 30% to 50% in equities, 50% to 70% in cash and fixed income.

Emphasis is placed on current income, with some focus on moderate 

capital growth. This objective is best suited for investors with little need for capital appreciation.

For retirement planning purposes, this is appropriate for investors in retirement who have a lower tolerance for risk and whose retirement assets are above target.


Income with Capital Preservation – Typically 10% to 30% in equities, 70% to 90% in cash and fixed income.

This objective is generally considered the most conservative investment objective. Emphasis is on generating current income and minimal risk of capital loss.

For retirement planning purposes, this is appropriate for investors in retirement who have a lower tolerance for risk and whose retirement assets are well above target.

Saturday, November 20, 2021

CAUTION! Speed Bumps Ahead

 We are in the middle of one of the seasonally strongest periods for equity markets, yet we have some potential speed bumps in the weeks ahead.

President Biden is expected to announce his pick for Federal Reserve Chairman before Thanksgiving. It is anticipated that he will either renominate current Federal Reserve Chairman Jerome Powell (R) or Fed Governor Lael Brainard (D). Many believe Chairman Powell has done an excellent job and should be renominated. Others think President Biden may choose Fed Governor Brainard as an appeasement to the more progressive wing of the Democratic party who may feel they were forced to capitulate on recent legislative issues. Both are highly qualified, and neither are expected to change the Fed's current path; however, any change at the Fed could cause a ripple through markets. I don't have any inside information, but if President Biden wants to make a change at the Fed, it may come after the market closes Wednesday, giving market participants something else to digest with their Thanksgiving turkey.


We're about to revisit the debt ceiling drama. You may recall that Congress approved an extension of the national debt limit in October. U.S. Treasury Secretary Janet Yellen has shifted her estimate of how long the government's debts can be paid from December 3rd to December 15th. We have never defaulted on a bond payment, and it is expected that after a period of public theater, Congress will again raise the debt limit. Defaulting on our debt is a low probability, high consequence event that could move markets as we approach a potential default. A default could result in missed bond payments, social security checks, and military payroll being delayed. Markets would have a dramatic reaction if the U.S. were to default on any debt.


After Thanksgiving, we can look forward to a potential government shutdown dominating headlines again. Congress did not pass the necessary appropriations bills in September to fund the government for the fiscal year, which started October 1st. Instead, Congress passed a (CR) Continuing Resolution to avoid a government shutdown. Congress must pass the required appropriations bills or another CR by December 3rd to avoid a government shutdown again. It is expected that Congress will opt to pass another CR, kicking the can down the road into next year. There is a risk that politics could come into play and force a temporary government shutdown. Markets do not like uncertainty or instability; however, the reality is that a government shutdown is not a permanent condition. Previous government shutdowns have not resulted in lasting economic harm.


After impressive 2021 market returns, many are sitting on significant taxable gains. With the threat of changes to the tax code, some may elect to sell into yearend to realize taxable gains in 2021. If we begin to see tax-related selling, I expect those funds to come back into the markets in January.


In recent weeks we've seen a rise in COVID cases again in thirty states and areas around the globe. As winter approaches, more people in colder climates are spending more time indoors. This week Austria reinstated a lockdown and mandated vaccination for their population. In neighboring Germany, there are broad restrictions for public transportation, restaurants, and other public venues. In some places, they are canceling holiday events. When asked about a lockdown in Germany, the German health minister said nothing could be ruled out. The rise in COVID cases has caused doubt in the expectations for global growth. Crude oil prices have fallen 4% to a six-week low. Growing economies have higher energy needs. If growth estimates are revised down, the forecasts for energy prices are also revised down. Although there is nothing good about rising COVID cases, the silver lining is that a slower global recovery will put downward pressure on energy prices and inflation concerns and could give the Fed more time to adjust monetary policy.


Do you remember that time when everything was good, and there wasn't anything to worry about? Neither do I. I don't have a crystal ball; I can't see the future or defy gravity. I expect we'll have increased volatility in the coming weeks as the political issues play out. The economy is in good shape, corporate profits have been better than expected, and earnings estimates have been growing. I don't worry too much about things that could cause short-term market gyrations. I'm watching for conditions that could lead to a recession. I don't see anything like that currently. I will continue to monitor markets and the economy and will keep you advised. Please call me with any questions or concerns.


Saturday, November 6, 2021

Economic Update - November 6, 2021

 A video version of this content is available on YouTube: Link to Video Podcast

An audio version of this content is available: Link to Audio Podcast

There was a lot of market-moving economic news this week. Wednesday, the Federal Reserve ended their two-day meeting and announced their plan to begin reducing asset purchases. The Fed has been buying $120 Billion per month in bonds, $80 Billion of US Treasuries, and $40 Billion of agency mortgage-backed securities to support the bond market through the pandemic. The Fed will reduce US Treasury bond purchases by $10 Billion and agency mortgage-backed securities by $5 Billion in November and December. It is expected that the rate of decreasing bond purchases will continue, and the Feds bond-buying program will end in the Summer of 2022. Chairman Powell indicated that adjustments could be made should economic conditions change. Chairman Powell reiterated that there is a higher bar for raising the Fed funds rate; raising rates is not expected until after the Fed has completed the tapering of their bond-buying program. Many believe the Fed will begin raising interest rates later in 2022 in response to increasing inflation pressures. The Fed has done an excellent job of communicating their intended path and not being surprised markets responded well.


Thursday, the Labor Department reported that weekly initial jobless claims fell by 14,000 to 269,000. This number was better than expected and marked a pandemic period low—March 14th, 2020, pre-pandemic initial jobless claims were 256,000.


Friday, The Bureau of Labor Statistics reported that nonfarm payroll employment rose by 531,000 in October, and the unemployment rate fell to 4.6%. This report exceeded expectations, and equity markets rallied to new highs. We are all aware of the labor shortages. Unfortunately, there is no end in sight. The most recent data shows that we have more job openings than human beings to fill them. When I was in business school, an economics professor commented that full employment was 5%. He opined that anyone who wants a job has one once you fall below a 5% unemployment rate, and anyone worth hiring has been hired.




Pfizer announced results from their clinical trial of its experimental Covid-19 pill. When combined with a low dose of an HIV drug called ritonavir, hospitalization or death were reduced by up to 89% among high-risk patients. On CNBC Squawk Box, the former head of the FDA, Dr. Scott Gotlib, said, “By January 4th, this pandemic may well be over, at least as it relates to the United States after we get through this Delta wave of infection,” he said. “And we’ll be in more of an endemic phase of this virus.”


With Congress contemplating infrastructure bills, and the possibility of the pandemic coming to an end, the labor market should remain firm.


Coming into October, there were those warning that markets were at risk of a significant sell-off. Inflation, the possibility of rising interest rates, the threat from higher oil prices, and a policy misstep from the Fed were all cited as reasons the bull market could end. All those risks remain, and I will continue to monitor the economic data. You should never be so confident in your investment outlook that you discount the risks. For now, I see solid corporate profits, a strong labor market, an accommodative Fed, and a potential end to the pandemic outweighing the risks. This past Friday, I adjusted the portfolio models during a scheduled rebalance. The most recent changes increased diversification and slightly reduced risk.

We are in a seasonally strong period for equity markets. Considering the solid economic data, we could see equity markets continue their upward trajectory into year-end. As I always say. I do not have a crystal ball; I can’t see the future nor defy gravity. I can monitor markets and economic conditions and keep you informed. Please call me with any questions or concerns.