Down, Up, and Sideways

Intro: Context Always Matters
With the fearful headlines of the day, it’s important to consider the context.  We are experiencing aftershocks from an event unprecedented in human history: coordinated shutdown of the global economy to fight COVID; then reopening with massive amounts of stimulus.  As the global economy reacts to this extreme shock, the data are all over the place, which makes it very hard to know what is going on and what will be the likely outcomes.  This period of aftershock is an era of dislocations and distortions, none more impactful than the transition to tighter monetary policies of rising interest rates and reduced liquidity. 

The End of Easy Money
The graph below goes back to the 1950s and shows just how dramatic is this shift in policy.  The blue line illustrates the level of the fed funds rate, the gray bars show recessions.  In the 1970s, the Fed tried twice to combat inflation by raising rates.  Each hike ultimately ended in recession.  But inflation persisted, becoming so entrenched and stubborn that to reduce inflation once and for all, then Fed Chair Volker had to jack rates all the way to 16%.  He was seen as a hero to many economists because, though this caused a deep recession, it killed inflation and set the stage for a long-term economic growth and bull market in stocks.  Reductions in rates from these super high levels added fuel to this growth.

Cuts Led to Zero Interest Rate Policy (“ZIRP”)
Crises of recent years (9/11, the Great Recession, the Pandemic Shutdown) prompted successive, even excessive, rate cuts until we reached zero in 2009.  The zero interest rate policy was supported by a large increase in money supply and massive government stimulus spending.  This all led to the inflationary economy of today, greatly aggravated by the war in Ukraine. 

The job now for Fed Chair Powell is to try and unwind this historically accommodative (stimulative) policy stance. The Fed has few tools: mainly money supply, interest rates, and the impact of articulating the direction of Fed policy.  These tools, though blunt, are powerful. 

This policy shift is the opposite of the stimulative programs of recent years and has been a central cause of the crumbling of stocks and bonds so far this year.  No one knows how long it will take the global economic system to settle down from this change in regime.  A resilient system will eventually settle into its new normal.

Down, Up, or Sideways.
There are no perfect historical comparisons to these unique times, but we can draw lessons from prior crises.  Where might the market go from here?  Let’s consider alternatives.  We know it can crash.  For this to happen, we’d need to uncover substantial fundamental risk such as the overleveraged consumer and toxic asset-filled banks of 2008—2009.  The risks we face today are high, but in my view not of the magnitude of the Great Recession.  Instead of crashing, the market could just grind lower.  The argument here is that year-to-date declines focused on rate increases; the next leg down would be due to earnings declines, the surging dollar, etc.  Ouch.

Conversely, the market can also go up for decades such as the period after Volker crushed inflation and the tech boom took off.  Current investor sentiment is very negative, which may not be justified.  Housing, the consumer, employment, are all holding up relatively well despite the deluge of bad news.  It is possible that the negativity is a contrarian indicator and the near-term future isn’t so grim as feared.  Also, inflation may have peaked, which could have several positive effects.

Beyond up or down, there’s a third possibility.  The market can go sideways, as it did from the late 1960s through the end of the 1970s.  After the “go-go” years from the post WWII period through the early 1960s, the markets turned flat… for over ten years.  We haven’t seen anything like this in decades.  But the argument for this is that super high growth of recent years was in part growth that we might have seen in the near future.  In other words, growth was pulled from the next few years back into the past five years, which means that we’ve already enjoyed that growth and won’t see it again.  A sideways market can create big challenges for investors.

Go Big?
One solution to all of this uncertainty is to make a bold bet and take a highly concentrated position that could pay off dramatically if things go your way.  Like in “The Big Short” this type of boldness is the stuff of legends and could bring notoriety and riches.  Or, of course, it could lead to tears.  Statistically, it is much more likely that high risk gambles lead to regret than to riches.  I just don’t have the conviction to advise clients to take a highly concentrated gamble.

Let’s Prepare for All Three:  Down, Ups, Sideways
Alternatively, now may be the time to simultaneously implement thoughtful preparation for all of the most probable outcomes: down, up, and sideways. In doing so, we’d likely underperform pureplay strategies.  But an all-weather approach could reduce risk and leave us positioned to take advantage of early stage trendlines, before they are definable.  For example:

Down
Possible catalysts: inflation persists, leading to continued Fed aggressiveness, geopolitical risks increase, deep recession takes hold.  Potential Investment Leaders:

  • Alternative investments could provide downside protection.
    • Bond ladders could become effective if built upon higher nominal yields.
    • Value stocks and dividend payers could outperform growth equities.

Up
Possible catalysts: inflation subsides, Fed slows actions, China eases lockdowns, earnings are durable, the dollar falls, and/or Ukraine war cools.  Potential Investment Leaders:

  • Growth could outperform value equity investments.
    • Index funds and ETFs could offer highly efficient vehicles.
    • Small and mid-caps could recover, even outperform large cap.
    • Developed international and emerging markets might finally surge.
    • Alternative investments could be a drag on overall portfolio performance.

Sideways 
Possible catalysts:  Growth slows to low single digits as metrics showing progress improve only gradually and are offset by equally stubborn negative metrics.  Potential Investment Leaders:

  • Income and dividend orientation could become as important, if not more so, than capital appreciation.
  • Stock dispersion around the mean could widen, meaning that many stocks perform. well above, and below, their indexes.  This means that active fund managers could outperform indexers.
  • Stock picking, especially of companies with high dividend yields and strong balance sheets, could become a critical means to achieve portfolio growth.

Conclusion
In these unique times, investors can take an all-weather approach to their portfolios.  At GFS, we are taking a close look at allocations and holdings, considering performance in down, up, or sideways markets.  We are preparing to simultaneously invest for all three. 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual security. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. 

The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.

Stock investing involves risk including loss of principal.  Asset allocation does not ensure a profit or protect against a loss.

There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio.  Diversification does not protect against market risk.

The data included is developed from sources believed to be providing accurate information.

Companies mentioned are for informational purposes only.  It should not be considered a solicitation for the purchase or sale of the securities.  Any investment should be consistent with your objectives, time frame, and risk tolerance.

Dollar cost averaging involves continuous investment in securities regardless of fluctuation in price levels of such securities.  An investor should consider their ability to continue purchasing through fluctuating price levels.  Such a plan does not assure a profit and does not protect against loss in declining markets.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

ETFs trade like stocks, are subject to investment risk, fluctuate in market value, and may trade at prices above or below the ETF’s net asset value (NAV). Upon redemption, the value of fund shares may be worth more or less than their original cost. ETFs carry additional risks such as not being diversified, possible trading halts, and index tracking errors.

The prices of small and mid-cap stocks are generally more volatile than large cap stocks

International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks are often heightened for investments in emerging markets.

Dividend payments are not guaranteed and may be reduced or eliminated at any time by the company.

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