11 Jul 2022
Resisting the urge to get out
Somewhere buried deep beneath the sands of time, there lies a cave where inscribed upon its walls is “buy low…”
Capital market prices do not rise all the time. We all know this, or at least we should. Furthermore, dislocations of prices are what creates most investment opportunities. Buy low and sell high is likely the oldest and most basic investment adage. However, during times of volatility, rarely do investors proclaim, “I look forward to volatility, I can’t wait to buy more”.
To help us all along the path of being a long-term investor, the following are perspectives of the current issues that are plaguing investors, but which could also ultimately lead to opportunities.
So far, this decline has been textbook
We began this year with the thesis that the combination of high asset prices and high inflation would lead to aggressive Fed policy. The Fed offered their first initial raise of interest rates in March at a paltry 0.25%, which in the face of 8% inflation, now appears laughable. However, they quickly recognized the need for larger rate hikes, and proceeded to raise rates two more times, first 0.50% in May, then 0.75% in June. It is also likely that they will raise the Fed Funds Rate by another 0.75% at the next meeting in July. This tightening quickly moves short-term interest rates closer to the bond market expectation of 3% (as implied by 2-year treasury bond yields).
Earlier this year we also suggested that the Fed would likely be successful in engineering an economic slowdown. Historically an economic slowdown has been an integral step to reduce aggregate demand, and in turn inflation. Predictably, this tighter and more meaningful Fed policy quickly hit asset prices of both stocks and bonds. Now, it is expected that the combination of both lower asset prices and tighter Fed policy could result in some form of a recession.
This sequence of these events shouldn’t be a surprise given the current inflationary environment. So far, this unravelling has been textbook, and it doesn’t seem different this time.
But we are in a bear market, that is bad right?
To answer this question, I will let a picture speak a thousand words. We could talk extensively about all the factors currently plaguing markets; inflation, interest rates, the economy, asset prices, supply chain, the Russian invasion of Ukraine, etc., but would only serve to distract from the big picture. At the time of this writing, the average U.S. stock, as represented by the S&P 500® is down about 20%. Rarely does the stock market offer you a sale.
Source: Morningstar. Calculations by Frontier. Past performance is no guarantee of future returns.
But we are about to enter a recession, maybe?
A recession is simply two consecutive quarters of economic contraction as measured by GDP (Gross Domestic Product). First off, we are not currently in a recession, although, there has been plenty of talk of the dreaded “R” word. Secondly, rarely do recessions last much longer than three quarters. Finally, and more importantly, stock prices usually lead the economy and can actually rise through a recession.
Stocks lead the economy, not the other way around.
This graphic depicts the relationship of stock prices and the economy, and within the green highlights we can see that stock prices fall in anticipation of a recession, but then rise throughout the period of contraction. This has been the case in most of the recessions that we have reviewed, but specifically, these charts relate to inflation-driven recessions.
Asset prices are lower, but are they going even lower?
Asset prices have quickly adjusted to the new economic reality. However, what everyone wants to know is, are asset prices going to go even lower? One can guess, but no one really knows the answer to this question. All a long-term investor can go on is measures of value. The most common and straightforward measure of valuation is the P/E (Price-to-Earnings) ratio, which is the price one pays for assets relative to the earnings they are likely to receive. For most equity markets, forward P/E ratios are now approaching levels only last seen in 2020 and 2008.
If you liked stocks 6 months ago, you have got to love them now.
Of course, the bear narrative implies that earnings are expected to decline, therefore these P/E’s are likely overstated. However, analysts don’t seem to think that earnings are going to decline much from this point.
Analysts seem to be downright optimistic about earnings.
Source: Yardeni
This chart of the evolution of earnings estimates shows the path of expected earnings year-by-year. Analysts generally start each year with optimistic outlooks, but then revise earnings estimates down, which is why many of the yearly lines are downward sloping. However, despite all the turmoil this year, analysts have remained optimistic, as depicted by the upward sloping line for 2022. This implies that earnings are expected to improve throughout the year! So, who is right, the stock market bears or the optimistic analysts? The truth is probably somewhere in the middle.
But I could just get out now and get back in later.
There are several ways to permanently impair an investor’s outcome. The first is to buy poor quality assets that can go down and stay down. Obviously, we try to avoid these types of assets. The second and more frequent impairment can happen when investors sell long-term viable assets at the wrong time.
Selling low can lead to impairment of an investor’s outcome
All this positive talk is not to convince investors to rush in and buy now, but to remind them not to bail out of meaningful long-term assets due to normal short-term volatility. Of course, the current issues that are plaguing markets can get worse, but it is a dicey game to try to pick the bottom. For that reason, Frontier strategies remain in what we believe to be conservative positioning, as after all, we are downside first managers. This conservative posturing should help investors stay put, as well as provide investors with a prudent manner in which to increase their positioning, if that is called for.
One year from now, we will probably be writing an article chock full of new issues that investors are worried about. There is always something to worry about! However, based on our experience, we believe this is a relatively normal asset price dislocation, and after 22 years of managing portfolios, we have seen our fair share of bear markets. As always, we remain on process and stand ready to adjust to how the world unfolds.
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A recession is a macroeconomic term that refers to a significant decline in general economic activity in a designated region. It had been typically recognized as two consecutive quarters of economic decline, as reflected by GDP in conjunction with monthly indicators such as a rise in unemployment.
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Inflation is the decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. The rise in the general level of prices, often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods.
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