...if someone has told you that there is a more than 50% chance we would see a sharp fall in equity markets in January, what would you do? Pull out now, pull out nearer the point, pull out when you start seeing it, or stay the course. Some don't even think about it.
...We Are the Choices We Make.
From Graham Summers (Part I)
This year, 2022, has been one of the strangest years in memory for the markets. Some of the stranger items of note:
1) During a time in which inflation was over 7% for the entire year, the $USD rallied nearly 20%. Even with the recent collapse, the greenback will still end the year up nearly 10%.
2) During a year in which a major armed conflict ignited in Eastern Europe, with the potential to trigger World WIII, Gold is down 2%.
3) During a year in which energy crises of sorts hit most of the developed world (Europe and the U.S.), oil is up only 2%.
4) Despite a war occurring in Europe, European stocks (the German DAX) outperformed their U.S. counterparts (-12% vs -18%).
5) Despite Russia being kicked out of the SWIFT payment system and suffering extensive sanctions, the Russian Ruble finished the year UP and is higher than it was PRIOR to Russia being kicked out of SWIFT!
As if the above items were not strange enough, 2022 was ALSO the year in which modern portfolio theory came crashing down. Since the early-1980s, the general consensus has been that bonds act as a hedge against stocks. In simple terms, when stocks collapse and the financial system goes “risk off,” typically bonds rally.
This has been the case for most “risk off” periods in the U.S. since the early 1980s. The below chart of the Great Financial Crisis serves as a decent example. The S&P 500 fell 38%, but long-term U.S. treasuries rallied 35%. Bonds acted as a hedge. This “stock/ bond hedge” framework is the basis for ALL modern portfolio theory.
Today, if you visit a financial advisor, there is a greater than 90% chance he or she will urge you to allocate a certain percentage of your portfolio to stocks and the rest to bonds. Typically, the younger you are, the greater the percentage allocated to stocks for capital growth. And as you grow older, this allocation is changed to favor bonds more and more until you reach retirement age by which time most if not all of your net worth is in bonds (for the income). Again, the “stock/ bond hedge” framework is the basis for ALL modern portfolio theory. And this year, 2022, it ALL went out the window. Both stocks and bonds collapsed this year. And not by a little: the S&P 500 is down nearly 20% while long-term U.S. Treasuries are down over 25%.
Even if you were to alter the portfolio’s construction to favor short-term Treasuries, you would still down almost 20% and 4%, respectively. Simply put, neither stocks nor bonds were safe this year. However, anyone who was in cash outperformed both dramatically as the below chart shows. Cash, as denoted by the $USD is up 10%. Even with inflation at 7% you STILL ended the year up slightly, which is more than can be said of stocks, bonds, housing, or just about anything. I hope this helps to clarify why I urged all of you to go mostly to cash in April and while I continue to emphasize that cash should be your largest position. The Everything Bubble has burst and we are in a period in which capital preservation is of the utmost importance. And as strange as 2022 was, I believe 2023 will be stranger. Indeed, I cannot think of another time in my entire career in which the cross currents in the markets are so extreme and so strong.
Some major forces playing out in the financial system right now:
1) High inflation vs. a recession/ demand destruction.
2) Ongoing supply chain issues vs. the end of globalization.
3) An extremely tight labor market vs. the Fed’s goal of raising unemployment.
4) China’s re-opening vs. demand destruction from a global recession.
5) The Fed’s ongoing monetary tightening vs. investors looking for any excuse to pile back into stocks thereby loosening financial conditions.
6) The Fed’s ongoing monetary tightening vs. over $92 trillion in debt securities in the financial system.
7) The Fed’s ongoing monetary tightening and its effect on bond yields vs. the $466 TRILLION in notional value of derivatives trading based on interest rates.
Depending on which of the above forces wins out in these seven respective battles, you would want to invest in completely different asset classes and securities.
For instance, let’s take #1. If the Fed abandons its goal of causing demand destruction/ inducing a recession to end inflation, (meaning inflation is permitted to rage at a much higher rate than what the Fed has previously deemed acceptable), then you would want to reduce your exposure to cash, load up on commodities or hard assets, and avoid bonds while shorting non-inflationary stocks.
By way of contrast, if the Fed doesn’t abandon its monetary tightening and does trigger a major recession, you’d want to be heavily invested in cash and bonds (especially short-term Treasuries) while avoiding most stocks as well as commodities like the plague. And that’s just #1.
We have at least SEVEN different “cross currents” in the above list and I’m sure I’ve left quite a few items out! Moreover, even if you were able to predict the “winner” in each of the above seven cross currents, unless you also get the timing correct, you can still lose your shirt. Let’s take this year (2022) for instance. The single defining investment theme this year has been that the Fed IS serious about ending inflation and that it IS NOT about to pivot.
If you had known with 100% certainty that this would prove to be the case at the start of 2022, you would have shorted Tech stocks as they were the bubbliest of sectors and therefore had the farthest to fall. Despite this being the “right trade” for 2022, depending on your timing, you could have easily been annihilated doing this. The NASDAQ had several large double-digit rallies as the below chart illustrates.
Had you shorted Tech stocks right before any of these, you’d have lost a LOT of money. Indeed, despite “shorting Tech” being one of the clearest trends in 2022, there were several months in which doing it was a LOSING strategy. The outcome would have been even more extreme if you’d concentrated on high beta, growth Tech stocks.
The ARK Innovation ETF (ARKK) is a decent proxy for that part of the market. In this example there were rallies of 20% to 50% throughout 2022! And despite shorting this sector being one of the biggest winning trades of the year, it hasn’t really made any money since MAY!
My point with all of the above is that investing in our current climate is quite tricky. Most of modern portfolio theory has been thrown out the window. Depending on how the numerous cross currents play out, you’ll want to have completely different allocation strategies. And even if you DO get the allocations right, unless you ALSO get the timing right, you can STILL lose a LOT of money!
I believe 2023 will be a continuation of this. Indeed, I believe it will be the year of crises (plural). The Everything Bubble has burst. And going forward investors will need to be nimble, moving into and out of various sectors and stocks depending on the circumstances
