Wesley Chapel, FL
Investors,
So, we finally got our first technical “correction” (a drop of 10% from highs) in the S&P 500 (SPX) Index in well over a year. The last correction was all the way back in September of 2020 leading up to the US Presidential Election. And even then, you have to either round up 10% (if using closing prices for the index) or use intra-day highs and lows to get the full 10% drop. The past year (aside from the past two months) has been one of the least volatile periods for the stock market in its history.
The lack of volatility has the impact of magnifying the current drawdown in the minds of most humans, particularly those who are new to investing and those who only pay attention to the market when the news starts writing headlines about it (typically when money is being lost).
Just to be very clear, there is no reason to panic or worry at all.
I may (or may not) have shared this before, but it is worth repeating. We have a client who once said to me, “I’ve never found panic to be useful.” It is funny if you think about that statement. While plainly obvious on the surface, think about it this way… imagine listening to a friend tell you a story where something bad happened to them, where they say, “and then I panicked, and everything worked out great from that point on.”
Nobody has ever said or heard that because it is basically impossible. Panic is never useful. Panic only serves to make a bad situation worse.
But that also doesn’t mean you do nothing.
There are only two ways to have money to invest in the best opportunities that are sure to emerge at the bottom of a market correction.
1. Sell some things on the way down, thus raising cash; or
2. Earn more cash to deposit into your account.
Guess which of those two options most advisors prefer…
At Elevate, we aren’t afraid to take some money out of the market when we hit a predefined stop loss. It is vital to define how much you are willing to lose on a position before you enter it. When the market starts to drop and money is being lost, humans become emotional and make poor decisions. But that is where the opportunity lies.
We also aren’t afraid to sit on the cash we raise through following our stops while the whole world around is panic-selling securities due to the latest headlines and uncertainty.
As I mentioned in last month’s commentary, as the markets were making new lows at the end of January “both [Growth and Value] strategies were sitting on a lot of cash and that is still the case, today [February 11th].”
Well, fast forward to today and we are sitting on even more cash than we were then. Since my last commentary, the market has made new lows twice, most recently just a couple days ago on March 8th when the SPX closed down 12.5% for the year. In fact, over the past couple days we have held more cash across our strategies than ever before, and I couldn’t feel better about it.
It feels to me like we are in a “developing” bear market. That basically just means that I think the market is on its way to being down 20% from its highest point (coincidentally achieved on the first trading day of the year, January 3rd, 2022).
Even if I am right, there will be a bunch of single-day and maybe even multi-day rallies to lower highs. During bear markets is when the markets seem to have their biggest up days. But each of those violent rallies leads to a lower peak, and then the drop resumes. This happens for several reasons, but the investor psychology is roughly like this:
1. Some uncertainty hits the market and people (including large institutional money managers) sell first and ask questions later. Many investors are down and wish they would have not been greedy and sold some stocks at the highs, but they don’t want to sell now with the market pulling back.
2. Many other people who have cash “on the sidelines” see the drop as an opportunity to put that cash to work and they “buy the dip.” In 2021, every single dip got bought ferociously and the market rallied to a new (all-time) high each time. Many investors, especially retail investors, have been conditioned to buy the market every time it dips a little.
3. As the market rises from all the dip buying, the folks who wished they had sold some at the highs decide to finally sell some stocks as the market is rising again. These sellers outweigh the dip buyers, and the market drops again. Selling begets more selling and the market falls to a new low.
4. Cycle repeats until finally everyone who wants to sell stocks has sold them.
SPY chart currently (click to enlarge)
SOURCE: Tradingview.com
See the nearby chart of the SPY ETF which tracks the S&P 500 for a visual aid. This is the cycle we are in right now.
As long-time clients and readers know, the 200-day moving average (DMA) is the line that separates long-term up trends from long-term downtrends. The 200DMA is represented by the light blue line on that same chart. When the price of any stock or index is above the 200DMA it tends to keep going up, and when it is below, you want to protect your capital and “look out below,” because things can deteriorate very quickly. Today, the major market indexes all trade below their 200DMAs, and that is a good reason to remain cautious.
I won’t start aggressively buying stocks again until the above cycle resolves, and the market reclaims its 200DMA.
How does the cycle I described above “resolve?” The market rises to a higher high, and then falls to a higher low. That is when I will want to take advantage of some opportunities to buy our best ideas at what amount to bargain bin prices.
SPY chart during COVID (click to enlarge)
SOURCE: Tradingview.com
See the other nearby chart of the SPY during COVID. It shows how fast things can deteriorate below the same 200DMA (light blue line) and then it also shows that the market rose to a higher high and dropped to a higher low – and that was the “all clear” signal to at least start buying back into the market.
You can also see on this chart all violent rallies to lower highs on the way down. Also notice how you didn’t need to pick the absolute bottom to make a lot of money on the upside once the market stopped falling.
Longer term SPY chart. (click to enlarge)
SOURCE: Tradingview.com
Again, none of this is abnormal. Its totally normal. As I also said in my last commentary, what is abnormal was 2021 where we didn’t have a single dip of 6% or more. In a normal year, the market pulls back on average 14% from its highest price.
So, we are by no means out of the woods yet. In fact, I still think that we can totally erase all of last year’s gains before the current drop is over. That would only imply another 10% of downside from the lows we saw the other day on March 8th and equate to roughly a 20% drop from the highs on January 3rd.
That would be enough to trigger a technical bear market. If it plays out that way, it will mean that we are actually in a bear market right now, which started on January 4th. Bear markets, corrections and recessions are a few of the events that can only be seen through the rearview mirror or by looking backward. You can’t see them through the windshield, or by looking forward.
Of course, there are no guarantees that it will play out that way – but it won’t surprise me one bit if it does.
What saved the market back during the COVID crash? Remember, the entire global economy was locked down. There wasn’t any commerce happening. There was no reason to buy stocks at the lows and there was really not much of an economic reason for the market to stop falling when they were down 30%, then.
What happened was the FED came to the rescue of the markets, and essentially said that they were going to print money for people to use to buy stocks. It really isn’t much more complicated than that despite what many in the financial industry want us to believe.
Sure, some money went to some people who needed to feed their families and pay their bills, but immeasurably more went into the financial system. It’s not like anyone could have used the money (at that time) to take their family to Disney Land, or even to movie theaters or restaurants because those places were all closed! And even if they were open, who would want to get on an airplane or stay in a hotel with a “deadly” virus on the loose?
As it turns out that the virus wasn’t quite as deadly as initially feared, and looking back, the damage done by shutting down the global economy (both economic and health damage) and rushing out vaccines at “warp speed” was probably a lot worse than the virus itself. We’ll have to wait and see how history ultimately looks back on it.
But for now, it appears that all the money printed ultimately manifested in the extremely high rates of inflation we see today. In a way only government interference could, our attempts to control a virus by shutting the world down led to negative oil prices in April 2020, and all the money we printed trying to restart the economy afterward led to the highest gasoline prices on record as of yesterday – breaking even the highs seen in 2008 when oil was $145/barrel.
A barrel of oil no longer costs negative money either – far from it, at $123/barrel as of a couple days ago.
And now (the moment you’ve all been waiting for) the media wants us to refocus our fears on a new crisis. This time, the crisis is largely contained on the other side of the planet. Russia has invaded Ukraine and that has further disrupted the already strained supply chains in the global economy.
And before you blame the Russians for the high gas prices, note that the price of gasoline is higher in the USA than it was in 2008 when the price of oil was 34% higher than it is today. So, it’s not only the price of oil that is the direct cause of the high price for gasoline. Sure, it’s part of it but that doesn’t tell the whole story. We are still (internally) working through why gasoline is so high relative to oil, and it looks like the US Energy Information Administration (EIA) has been looking into it too. Here is what their analysts came up with.
As a country, we don’t do much business with Russia. We certainly don’t do much business with Ukraine. Russian exports were $406 Billion in 2019, and global GDP in 2019 was $87.6 Trillion. So, Russian exports in total made up 0.46% of global GDP. 60% or so of those Russian exports were energy related. The next highest category was metals at around 10%.
I am not saying that the conflict doesn’t matter. But I am saying that it is not as big of a deal economically as the media is making it out to be. At least for now. Shocker. The media making something scarier via headlines than it is in reality, is hard to believe right? No. No it’s not. This is what they do.
I personally don’t have any idea what is going on in Ukraine. But I suspect Mr. Putin is getting exactly the reaction he expected, and it is somehow part of the plan.
I do not think that the USA or anyone else will do anything to stop him from taking Ukraine over, if that is what he really wants to do.
That said, inaction by the USA and others could be the beginning of something much larger…
For example, most people consider WWII to have begun when Hitler invaded Poland in 1939. But four years earlier in 1935, Hitler took control of the Saar region which was punitively taken away from Germany in the Treaty of Versailles at the end of WWI. When nobody even tried to stop him, he was emboldened and a couple years later in 1937, went on to reoccupy the Rhineland to “reunify” Germany…
Sound familiar? Depending on if you believe media reports of Putin wanting to “reunify” the Soviet States, it may sound a little too familiar. Especially when you consider that Russia took back Crimea back in 2014 and now is invading Ukraine. Sure, more time passed in between, but it seems an eerily similar playbook.
Anyway, even though we don’t directly do much business with Russia, all those who do (or did) will be looking for new suppliers for oil, gas and metals. That increased demand and decreased supply will have the impact of pushing prices higher. These price increases are not inflation by the way – they are due to supply/demand imbalance.
But that said, the FED is responsible for “price stability” and prices are anything but stable. They are rising in parabolic fashion in many cases – especially in the energy markets.
All this gives the FED even more reason to tighten monetary policy by:
1. Stopping the purchase of bonds in the open market (which they finally did yesterday with their final transactions of the QE4 program instituted during the COVID crash).
2. Increasing the overnight lending rates that banks charge each other for reserves.
3. Reducing the size of their massive balance sheet by selling or otherwise not reinvesting capital from maturing bonds which they bought during the four QE programs since the Financial Crisis in ’08-’09.
And here is the main point of my commentary this month. The FED tightening monetary policy into a slowing domestic economy (GDP Growth Slowing) is going to be a much bigger deal than the current level of conflict between Russia and Ukraine – at least in the short term.
This morning the Bureau of Labor Statistics (BLS) published their Consumer Price Index (CPI) data and it showed again that the rate of change for inflation is slowing. Again, inflation is still very high, and I expect it to remain high for some time – but it isn’t increasing at an accelerating rate, rather it is increasing at a slowing rate. And the rate of change (ROC) is what is most important, in my opinion.
Year-over-year (Y/Y) CPI needs to come in at 8.3% on average for each of the three months in the first quarter of 2022 in order to maintain the Y/Y ROC from fourth quarter 2021. So far, Y/Y CPI for January was 7.5% and this morning we found out that Y/Y CPI for February was 7.9%. That means the average for the current quarter is only 7.7%, well short of the 8.3% number that is necessary. That means CPI needs to be 9.5% in March 2022 when reported next month (on April 12th) to catch back up and show a Y/Y ROC expansion.
Anything is possible, especially with the spike in energy and other commodity prices due to the Ukraine conflict. But I think it more likely that we will not get to the 9.5% number in the April 12th report, and then by the time we get to the May report the base effects (as discussed in my last commentary) will be in full force making the comparisons even more challenging to maintain the ROC expansion.
There is so much more that I would like to discuss, but unfortunately, I have plenty of other work to do and a deadline to meet! So, for now, I will move on to performance and outlook.
Market Indices
The S&P 500 Index (SPX) was down 3.14% in February and the Nasdaq (COMP) was down 3.43%. Just like in January, the market rallied in the last few days of the month to avoid finishing much lower. The SPX was down 6.42% for the month of February as of the close of business on 2/23, while the COMP was down 8.44% at that time.
To find out how your portfolio held up compared to the market dropping pretty hard (at the lows) please click here to login to your personal performance portal.
If you need a walk through of how to find what you are looking for, please shoot us a quick note to schedule time or to get help on the fly.
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Outlook
As I outlined last month, I do expect inflation to moderate – that doesn’t mean I expect deflation (where CPI declines.) Sure, that could happen if the FED tightens too fast, or too much, too soon. But it isn’t my base case. I expect high inflation to be with us for several quarters.
I still expect the FED to raise rates at their next couple meetings, before likely backing off to take a “wait and see” approach. Remember, they claim to be “data dependent” so they will always be behind the curve. Don’t expect the FED to take preventative action to stop things from getting out of hand – things are already out of hand on the inflation front and the FED is largely responsible for that.
Due (I think in large part to the Ukraine conflict) the FED has already mostly backed off its “threats” to raise rates by 0.50% at their upcoming meeting. Chairman Powell stated during his recent testimony before congress that he intends to “propose and support” a rate hike of only 0.25%.
Real Yields (click to enlarge)
SOURCE: JP Morgan
I am glad they are going to take a small step in the right direction, but it won’t help the economy overnight. In fact, the FED could raise rates by 0.25% five times, and inflation could fall by half and real interest rates (using the 10-year treasury) would still be negative. Negative real interest rates (the interest rate minus the inflation rate) are abnormal and a sign of a weak economy.
I still expect more downside for the stock market this year, even though we have dropped to new lows since my last commentary. There is probably more downside in store for bonds too, so the typical 60% stock and 40% bond “pie chart prison” portfolio, in which so many are stuck may not fare so well.
FED Balance Sheet (click to enlarge)
SOURCE: JP Morgan
And while I still expect the market to finish the year with gains, that is not a sure thing – especially if the FED follows through on its “plans” to reduce their balance sheet. I discussed this in my December commentary, but the short version is that the last time we finished a calendar year with losses in the stock market was 2018. That was the only other year in history that the FED was reducing the size of its balance sheet.
So, I still think a combination of stocks and cash is where we want to be. And we will take some calculated risks in trying to cautiously and responsibly get some of our cash invested into our best ideas even before they begin to make higher lows. That is the beauty of having cash at the bottom of a correction or bear market. We can afford to take a few relatively smaller shots before we get the signals to aggressively buy.
And of course, we may get stopped out of more positions (including some of those smaller shots) along the way. But eventually, the market will turn higher when everyone who wants to sell has sold, and so long as we are taking those shots along the way – a few of them are bound to end up being great buys for the next bull market that is sure to develop.
If you have friends or family with some financial resources invested in the stock or bond markets, they are likely down quite a bit for the year at this point and they are likely still fully invested with very little cash to take advantage of developing opportunities. When they call their advisor (assuming the advisor answers the phone at all) they are probably told to “stay the course” because “you can’t time the market,” and other nonsense. The truth is that if you want to beat the market, timing is everything. And it is very easy to beat the market when it is falling – all you have to do is follow a rules-based stop loss strategy. And then you have cash to take advantage of new ideas.
We are once again accepting new clients. So, if we can help someone in your network who isn’t sleeping well during this volatility, please let us know. We would be honored to accept your referral and appreciate the opportunity to help those who appreciate what we do.
Until next time. I thank God for each of you, and I thank each of you for reading this letter!
Shane Fleury, CFA
Chief Investment Officer
Elevate Capital Advisor
Legal Information and Disclosures
This commentary expresses the views of the author as of the date indicated and such views are subject to change without notice. Elevate Capital Advisors, LLC (“Elevate”) has no duty or obligation to update the information contained herein. This information is being made available for educational purposes only. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Elevate believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. This memorandum, including the information contained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written consent of Elevate. Further, wherever there exists the potential for profit there is also the risk of loss.