Since the end of 2021, some of the speculative froth that we saw during COVID has continued to come off the boil. This needed to happen because markets with excessive speculation are unhealthy and risky.
Many asset classes were down in the first quarter. Stocks, as measured by the S&P 500, were down 4.6% for the 1st quarter. Bonds were even worse, with the 10-year treasury down 6.6%. The tech-heavy NASDAQ was down 9.1%.
Below is a graph of the Goldman Sachs Non-Profitable Tech Index—one measure of speculative froth in the market. As you can see, that index declined from 275 at year-end to 150 in the middle of March (a 45% decline). Then it bounced 30% (to recover about 1/3 of its losses).
Those ill-prepared for a reversal of widespread speculation had a terrible quarter.
The reason why the 1st quarter was challenging for most is because financial conditions (the availability and price of credit in the markets) tightened significantly—making speculators more cautious. Some of the factors that caused financial conditions to tighten were stock price declines themselves (and an increase in volatility); rising interest rates and, in particular, mortgages; widening bond spreads (the difference between non-government and government bond yields), rising consumer and commodity (food and energy) prices; the decline in globalization; and an increasing likelihood of more US government regulation and taxes on individuals and businesses.
One of the main challenges for both investors and consumers today is inflation. Inflation has put upward pressure on interest rates. Rising rates, in turn, tighten financial conditions because capital becomes scarcer as investors demand more reward (interest, profitability, etc.) to lend or invest their capital. Inflation also negatively impacts business’ profitability because of rising costs, i.e., materials, labor, rent, etc., that may not be able to be passed on. Lower multiples (price-to earnings, price-to-sales ratios, etc.) is the market adjustment.
As the chart of 30-year fixed mortgage rates below shows, lenders now demand more return to lend money. The 30-year mortgage saw a 0.82% increase in 3 weeks—the biggest spike in rates since 1987. As of the writing of this letter, 30-year fixed mortgages are 5.03%—back to 2013 levels. This will have an impact on housing demand and residential housing prices.
Naturally, the focus of investors is now on what will happen with inflation. The bond market tells us it will come down to 2.3% in the longer run. How do we know what the markets expect? Without a long-winded explanation, we can look at the 5-year/5-year TIPS spread (see graph on the next page) to see what market-based inflation expectations are:
What this graph above depicts is the fact that bond market participants do not see inflation to be a long-term problem (5 years out) and that inflation expectations are still well-anchored despite recent CPI statistics. The Fed’s “comfort range” for inflation expectations is 2.3% - 2.5%, so the market is still projecting it at the low end. Apart from an over-stimulated economy, today’s inflation is mostly the result of supply problems, high levels of savings (pent-up demand), a tight labor market and pandemic-related consumption being more oriented to goods rather than services. These factors could easily abate as financial conditions tighten. There are signs that supply chains are easing such as the number of ships on anchor off of Long Beach being cut in half. The labor market should improve, and consumption should shift back to services.
The latest CPI (consumer price index) reading of 7.9% inflation is the highest level since 1982, which obviously has caused some rumbles in investment markets during the first quarter of 2022. Below we see what the prices of fertilizer have done in the last year, which has led to higher food prices that in turn has squeezed the working class, retirees and low-income families. In other words, there is a significant economic effect for a lot of people.
As the market adjusts to the reality of inflation, tight financial conditions, and potentially slow economic growth, the future could easily bring a painful rendezvous with reality for those legions of investors and speculators positioned in yesterday’s winners, richly priced tech stocks and myriad speculations.
As far as our investment strategy goes, we still see many attractive long-term opportunities outside of the speculative realm. The speculative realm being mega-cap tech stocks, unprofitable companies, private equity, meme stocks, crypto, SPACs, leveraged ETFs, etc. Selectivity will be key. There are big value differences observed across the investment market. For example, the S&P 500 trades at 19.7 forward earnings estimates (expensive) and emerging markets stocks trade at 12.1 times forward earnings (cheap). As Charlie Munger said, “We don't leap seven-foot fences. Instead, we look for one-foot fences with big rewards on the other side. So, we've succeeded by making the world easy for ourselves, not by solving hard problems.”
In that spirit, we focus on where the values are. In an environment where financial conditions are likely to continue tightening, it is prudent to have investments that don’t carry much long-term downside and can hold up well in a challenging environment.
We believe that value resides in investments that have remained unloved during the COVID-related speculative frenzy. Investments such as energy, defense, industrials, materials, agriculture, certain financials, emerging markets, and gold.
The investment backdrop is complicated, which makes predicting markets extremely difficult if not impossible. We have written about the challenges, so we will default to avoiding imprudent risk and trying to find value. Even cash is risky today. With markets themselves having already done much of the hard work for the Fed, we tend to think that inflation in consumer prices will continue for a while longer but will not be a persistent problem.
Warren Buffett says there are two rules of investing: 1) Don’t lose money; and 2) Don’t forget rule number 1. On that front, there are two primary ways to lose money in investments: 1) Through volatility which is normal and unavoidable, and that time tends to mitigate; and 2) Through investments made with a false sense of value, aka overpaying. The second way leads to a permanent loss. It is our mission to avoid permanent losses.
We hope that you have enjoyed the spring so far and we wish you the best for the upcoming summer. Thank you for your interest in our communications. We work hard every day in order to make high-quality decisions for our clients, to be informative and thoughtful in our communications and to deliver a superior experience. We hope to hear from you soon.