May 9, 2022

Wesley Chapel, FL

They finally broke it… if it looks like a duck, walks like a duck, and quacks like a duck, it is probably a duck… or in this case, a bear. A bear market that is.

It sure feels like a bear market to me but the S&P 500 (SPX) still hasn’t dropped the full 20% from its recent high price. The big Exchange Traded Fund (ETF) that tracks the index, SPY, is down 16.65% from its all-time (and recent) high price of $477.71 to close today at $398.17. And more downside is probably on the way…

Of course, I could turn out to be wrong about currently being in a bear market if the index doesn’t ultimately drop a full 20% before making a new high. Back in my March Commentary, I said:

“It feels to me like we are in a ‘developing’ bear market.”

So far, nothing has really changed my mind even though the market was up a bit in March.

Elevate Market Chat 5/5/2022
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In fact, if you listen to or (preferably) watch the Elevate Market Chat that I recorded with Kyle last week on Thursday, you will know that I am probably as bearish as I have ever been. And I am not alone…

I have quoted legendary investor/trader, Paul Tudor Jones (PTJ) more than once in these commentaries so long-time clients and readers should be familiar. In a nearby video you can see his recent interview on CNBC where he said,

“I think the FED (Federal Reserve Bank) is facing one of the most challenging periods in its history.”

“I think the FED is facing one of the most challenging periods in its history.”
Paul Tudor Jones on CNBC

That history goes all the way back to 1913, and includes the Great Depression, the Dotcom Bubble, the Great Recession, and everything in between. And the FED has not only presided over all of those events but probably also bears at least some responsibility for causing them.

I think we’d be better off at the mercy of the normal capitalist economic/business cycle, without human intervention. Sure, the booms and bust would probably be more frequent, but they’d also probably be less extreme.

One can hope…

Click to enlarge
*SOURCE:* *Sentimentrader.com*

Another reason to be bearish is the poor performance of most stocks in the Financial sector, which includes all the banks and brokerage firms. As of May 3rd, Sentimentrader reported that less than 5% of those stocks were trading above their 50 day moving averages and similar environments have generally led to poor returns for both the sector and the S&P 500 overall. Financials currently account for about 11% of the S&P 500 index.

Also according to Sentimentrader, selling pressure in investment-grade bonds has hit a 17-year extreme with last week seeing nearly 70% of bonds falling to a 52-week low. You might assume that this would be a buying opportunity but history shows that returns tend to be below-average following washouts like this one. In fact, the situation wasn’t all that different two months ago and it has only deteriorated since.

This sort of behavior in the bond markets hasn’t really been witnessed in the past 30+ years. And that is no surprise given that interest rates have generally been on a one-way trip downward during that time. Interest rate cycles tend to last decades… Rates have been falling since their peak in the early 80’s but before that rates had been consistently climbing higher from the the mid-40’s… And now we are seeing rates rise at a historic pace. This is very bad for the price of bonds.

In fact, using the SPY and LQD exchange traded funds to measure the performance of the “classic” 60%/40% stock/bond balanced portfolio this year, the return is a miserable -16.14%. And this is supposed to be a relatively “safe” balanced portfolio. The idea is that bonds always go up when stocks go down, and vice versa. Well, that is not playing out today. The Investment-Grade Bond ETF (LQD) is down a little over 16% for the year - right behind the SPY.

As I said in my March 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.”

Thankfully, at Elevate we don’t lock our clients up in “pie chart prison,” and then manage expectations like the vast majority of the financial services industry. Instead, we manage the capital and we aren’t afraid to sell securities and sit on cash when the odds aren’t in our favor. To that end, back on April 25th, we called an internal meeting to discuss the idea of proactively moving toward a 50% cash allocation for both our Growth and Value Strategies, and implemented that idea the following day. So far, I am glad we did.

Right now, the “FED Put” (where the FED comes to rescue a falling stock market) is not in place. If you believe the recent commentary out of the FED, the central bank’s primary concern is the stability of prices in the economy. The way to stop prices from going up so much is to increase the value of the US Dollar by increasing interest rates also referred to as “tightening monetary policy.” These higher interest rates are exactly the opposite of the FED Put. Today, the FED wants prices to stop going up, and so they are actively working to make that happen. That means the same downward pressure for stock and bond prices as it does for food and energy prices.

Click to enlarge
*SOURCE: Hedgeye Risk Management*

We are in QUAD 4 where both inflation (CPI) and GDP are decelerating (or falling in the case of GDP). When the FED tightens (raises rates) into QUAD 4, asset prices have crashed 100% of the time, according to our friends at Hedgeye Risk Management.

Eventually, the QUAD 4 environment will lead to dovish behavior, where the the FED is inclined to loosen monetary policy by lowering interest rates. But for now, the FED is at least saying they are committed to getting price increases under control which means we could be stuck here for a while. Perhaps as importantly, the current administration in the White House is on board with the FED’s plan to fight inflation. We’ll see how committed they are when people start losing jobs which has only just begun.

Despite my bearishness, and the fact that we might already be in a bear market (which we won’t know for sure until the SPX either drops a full 20% to below 3,837.25, or makes a new all-time high above 4,796.64) the stock market will experience violent rallies higher. These a rallies might last several days and might take the index several percentage points higher each time, before ultimately failing. We experienced one such rally last week on May 4th when the FED announced that they were raising interest rates by 0.50% and the SPX rallied by 3.05% in one day before ultimately failing and dropping to new lows. That was a selling opportunity.

Click to enlarge | SPX monthly chart
*SOURCE:* *Tradingview.com*

The last time (and only other time) that the market rallied more than 2.25% on a day where the FED hiked interest rates was in March 2000. That represented the (then all-time) high of the Dotcom Bubble and from there, the S&P 500 dropped around 50% over the course of 30 months before finally finding its bottom for that cycle.

30 months is a long time to be in a down market. I am not calling for history to repeat itself here - but even if it rhymes we could be in for a bumpy ride for a while. The point is that the market can fall a lot further than anyone thinks possible and it can take a lot longer to complete the bottoming process than anyone thinks possible. There are never guarantees in this line of work. This is why we prepare, we don’t predict.

And we also don’t try to be a hero and pick bottoms. The market can always go lower. And even though I think this move has so far been totally rational, as the saying goes, “markets can stay irrational longer than you can stay solvent.”

You might be saying to yourself,

“this sounds like timing the market, isn’t timing the market impossible and bad?”

Well, in a word, no. Not only can you time the market, but you must time the market if you want to get anything other than the index return minus the fee you pay to your advisor. Many advisors who have a poor track record of trying to time the market (either on their own or for clients) say things like,

“its not about timing the market, its about time in the market,”

Missing the 25 best days in the market…
**Click to enlarge** | *SOURCE: Michael Batnick, CFA*

and other clever things. They will show you a chart outlining how bad your return is if you miss just the 25 best days in the market each year, and use that to get you to keep your nest egg invested for the long-run no matter the economic environment.

Then, they will go to their next sales meeting and say the exact same stuff to the next prospect. They spend their lives “selling” you and others a pie chart of funds and they almost never have any advice about when to get out of those funds. And they do no portfolio management of their own, instead, they manage your expectations by saying things like “markets always come back.” Many go so far as to advise you to add money to your accounts whether the market is up, down or sideways. To a salesman, it’s always a good time to buy!

It is amazing how that works when earning your living (as a pie chart salesman) depends on getting more and more people to contribute as much as they can afford while they are working, and then to distribute as little as they can live on once retired. This behavior only serves to increase the amount of assets under management on which the advisor’s firm gets to charge fees.

How do these advisors get cash to buy at the bottom? They do a call campaign to all their clients and prospects encouraging them to add to their accounts. How can they identify a bottom (a good time to buy) if they can never identify a top (a good time to sell)? The answer: they can’t. But just because many can’t, doesn’t mean that nobody can.

This is in stark contrast to what we do at Elevate where through following a rules based strategy that includes trailing stop losses, we always have cash to invest at the bottom of the market without ever needing our clients to make additional contributions. Sure, if someone has cash available to invest, doing so at the bottom is advisable, but we routinely tell prospects and clients when it is not a good time to invest new capital.

That is just one part of what it means to live up to our company mission statement, to:

“Tell you what we would want to know if our roles were reversed.”

It’s a simple mission. But it is effective.

Missing the 25 best **and worst** days in the market…
**Click to enlarge** | *SOURCE: Michael Batnick, CFA*

What I would want to know if our roles were reversed is that the 25 worst days in the market each year often follow the 25 best days. And, I would want to know that if you miss both the 25 best days and the 25 worst days each year, your return would have beaten the market return over the past couple decades, with less downside volatility, as the nearby chart shows. Finally, I would also want to know that the vast majority of the best and worst days occur during times of high volatility while the market is trading below its 200-day moving average (like it is right now.)

At Elevate, we don’t generally go to 100% cash, and we likely wouldn’t completely miss entire days of market performance. So, this isn’t meant to be representative of any strategy that we offer but I thought this was an excellent illustration of how good the financial services industry is at getting the general public of investors to put their hard earned money into the market no matter the conditions.

One other thing I would probably want to know if our roles were reversed is what sort of return would be required to recover, or get back to even, after a loss. Many people think if they lose 20% they just need to make that 20% back to recover. Many people would be wrong. As the losses get bigger, the required return to get back to even gets exponentially bigger. See the chart nearby. This is why we follow stops, and focus on protecting capital even if we have to sacrifice some upside to do it.

Another way to think of it is that anything can drop by 50% or more. No matter how high it goes first, a 50% loss is a 50% loss. And to get back to even you now need the stock that just dropped 50% (probably for good reason) to double - and all you get out of that double, is back to even.

In the meantime, there are probably 100 other stocks you could buy to recover some or all of your loss. So, again, setting stops and then following them (no matter how much we like the company) is the key to protecting capital and keeping gains in the long run.

For now, as I said in last month’s commentary (and I think Paul Tudor Jones confirmed in his recent CNBC interview referenced above):

“The FED has painted itself (and our country) into a corner. Either they tighten (raise rates) monetary policy into a slowing economy (GDP and CPI) which will make a recession worse, probably leading to massive unemployment and social unrest. Or, they act to save the stock market by easing monetary policy (cutting rates or printing money to buy more bonds) and leading to ever higher inflation and a worse economy in the long run.”

My view is that we will have the rest of our lives to buy stocks on dips when the market finally turns bullish again. That doesn’t usually happen overnight or with one or two good earnings reports. I don’t think it is a good service to you, our clients, to sit here and complacently say that we should aggressively buy stocks because they are on sale, or because we see a multiday bounce, even if the stocks of good companies are cheaper than they were just a few weeks or months ago. I am not smarter than the market. I am content to sit, and wait, and watch, and when the market finally turns bullish again, the FED finally turns dovish again, and the economy finally seems healthy again (or some combination of the three) we will invest more aggressively when those odds are more in our favor.

On Wednesday, May 11th, we will get data on consumer prices (CPI) during the month of April. I expect the the report to show that inflation is decelerating. I covered this situation in detail in my February Commentary. So, we’ll get to see if I was right or wrong.

If I turn out to be right that inflation is decelerating, and if the market is down enough between now and then, I sort of expect the FED to hit the “pause button” on further rate hikes in their June meeting. If the FED pauses rate hikes in June, you can expect the market to bounce higher very quickly. Because of that, we will be scouring the market for a few good investments to make leading up to that event. But we’ll still probably hold plenty of cash going into the meeting. If I am wrong, and inflation does not show signs of slowing, or if the stock market isn’t down big enough for the year at that time, they will likely continue hiking rates as planned.

Also starting on June 1st, the FED is going to start letting the maturing bonds it has purchased during the past several rounds of Quantitative Easing (QE) “roll off” its balance sheet. That means they wont replace those bonds with new ones. This will have the impact of forcing interest rates higher by removing the largest buyer of bonds in the market and forcing the dollar higher by taking dollars out of the system. The last (and only other time in history) the FED executed Quantitative Tightening (QT) was in 2018 - and 2018 was the last year that the stock market was down for a full calendar year.

If I look back at the biggest mistakes I have made in my personal and professional investing career, they have almost all been a result of not patiently following a rules based process. So today, patience is the key to conserving capital and having cash to deploy when the market turns. And I can assure you that I wont be able to “pick the bottom.” That isn’t my goal nor is it the point. Goal number one is to protect your hard earned capital.

Until things change, I expect to carry a lot more cash than usual while still looking for investments that represent acceptable risk/reward ratios and diligently following our stop loss rules.

Until next time, I encourage clients to log in to your performance portal to review how your portfolio has held up in light of these challenging market conditions.

As always, I thank God for each of you, and I thank each of you for reading this commentary.

Please send feedback, comments, questions and concerns to info@elevatecapitaladvisors.com.

Shane Fleury, CFA
Chief Investment Officer
Elevate Capital Advisors