By David R. Guttery, RFC, RFS, CAM
President, Keystone Financial Group-Trussville Al
I celebrated my 31st anniversary of being in practice in December of last year. Across all of those years, in my opinion, 2022 will certainly be remembered as the most unique year, that demanded an extraordinary effort to navigate unusual circumstances.
Before we delve into my thoughts for the coming year, let’s briefly recap what made the previous year so odd.
Within last month’s article, suggested that if I had to caption the behavior of the markets in the previous year, I would describe it as being “shocked”. In November of 2021, the Federal Reserve began to nebulously hint at the thought of tapering. By January 2022, they also described the process of tightening, with an equally noncommittal description. Simultaneously, we were hearing about the transient nature of inflation.
Well, if tightening is the process through which inflation is controlled, and with both the Department of the Treasury, and the Federal Reserve suggesting that inflation is short-term and transient, then I believe markets anticipated that any subsequent approach to tightening would be mild.
Then, in March of last year the Federal Reserve rolled out what has proven to be the most aggressive approach to tightening in the last 35 years. I do not believe this is what markets anticipated, and it galvanized the attention of the market. Rather than focusing on the coming years, markets became very fixated on the coming days, and when markets become shortsighted, it becomes increasingly easy to overly price nefarious assumptions into current valuations.
As the Federal Reserve tightened throughout the year, among other things, this involved selling treasury securities in the open global market that were purchased with printed money over the previous 30 months.
As this occurred, prices dropped sharply, and yields rose sharply. This resulted in a yield curve that hasn’t then this inverted since 1981. For context, I was in the sixth grade when that last happened. Clearly, this has created significant, and unique challenges with regard to the fixed income portions of our portfolios.
Normally, when building sleeves of fixed income into portfolios, we are looking for negative correlation. This means that we are looking for an element of the portfolio that will add buoyancy during times of volatility. In most years, we are able to obtain that from a laddered sleeve of fixed income bond investments, and particularly from treasuries. We were not able to achieve that last year however, as bonds and stocks became positively correlated for the first time since 1972. Again, for context, I was three years old at that point.
Indeed, it is rare to see treasury securities post two consecutive years of negative results. That has only happened three times since 1928. Prior to 2022, the last time we observed treasury securities posting losses in consecutive years was in 1959. Again, for context, my parents weren’t even dating at that time.
In the third quarter of 2022, the Bureau of Labor and statistics told us that inflation at the consumer level reached a point that we had not seen previously since the year 1980.
As this was happening, we almost observed a new, near-term record high in terms of dollar strength against the global basket of currencies. This is extremely odd when simultaneously dealing with a 42 year high on consumer price inflation.
In October, the University of Michigan consumer sentiment survey posted the lowest reading in the history of the metric going back to 1960.
If you think of a string of dominoes, when one is set into motion, the rest of the dominoes will be impacted, setting off a chain reaction. The actions of the Federal Reserve were driven by the need to arrest not only a historically bloated balance sheet, but also to arrest a historically high amount of money in the lendable system. This excess money, and bloated balance sheet, were necessitated by congressional measures taken to support an economy that had shut down for the first time in history over a disease no one had heard of prior to 2019.
I could go on, but you get the point. These are just a handful of occurrences that we had either never seen before, or had not seen in many decades. Anecdotal evidence comes at a premium during such times. It’s hard to glean insight as to what might happen next from historical evidence, when there either isn’t any, or very little. So, I would characterize last year as being a shocked market, amid extremely unusual economic developments. With that context, we can begin to imagine how the current year may unfold.
I am encouraged by signs that market and economic conditions are beginning to stabilize. With regard to market volatility, if there is any anecdotal evidence to suggest that markets may have found their bottom, it would be in the form of capitulation.
At a high-level, this is the average market participant hitting a point of emotional exhaustion, and locking in losses. Just get me out. Quantitatively, capitulation in my opinion looks like this chart.
At the end of September, we had an extremely high ratio of open put options to open call options. On the top chart, you can see that this peaked at the end of September, and furthermore it was the highest indication of volatility that we had seen since Covid caused the economy to shut down. On the bottom chart, bearish sentiment had not been this strong since September 2008, at the beginning of the great recession.
In and of itself, this really isn’t enough to feel comfortable that markets may have found their bottom. We must crosscheck that with other quantifiable metrics.
Taking a stochastic look at the market, it would appear that we bounced off of the same Bollinger band on four occasions last year, in February, and again in May, and again in July, and finally again in September. A double bottom is certainly encouraging, the triple bottom is very exciting. A quadruple bottom, in terms of stochastic analysis, is very rare. If you see one, you should pay attention to what the market is telling you by its actions. It’s even more rare to observe a quadruple bottom within the same year.
I did not draw this chart. The market drew this chart with its actions. Stochastics, at a high level, is a fancy way of saying let’s play connect the dots. You observe patterns of behavior, and plot those dots. Connecting those dots form what we call Bollinger bands. In the media, when you hear that markets are running into support, or resistance, it is to such Bollinger bands that reference is being made.
So, as it pertains to market volatility, in my opinion, I do believe that markets have found their bottom, and we have stochastic evidence to support that conclusion. Volatility will likely be elevated throughout the first half of the new year, but I also believe in that it could abate from elevated levels over the latter half of the year. That depends on the Federal Reserve, and how consistently they remain true to guidance given in early November of last year. It also depends on how quickly the markets can find assurance that the Fed will not deliver another shock.
It would also appear that the unusual strength of the US dollar against the global basket of currencies is subsiding as well. In previous articles, I mentioned that a strengthening dollar can negatively impact assumptions of earnings when weaker foreign currencies are used to purchase a company’s product in foreign markets. Throughout the year, as the Fed continued to follow a policy that was more restrictive than any other seen in the last three decades, the dollar became very strong against the global basket.
Since the November meeting of the Federal Reserve however, the dollar has relinquished quite a bit of the strength. If you’ll recall, in the article from October, I offered my opinion that the Federal Reserve would find the latitude to acquiesce, and pursue targets of tightening at a slower pace. I suggested that if this happened, we might observe the dollar relinquishing some of the strength that had caused markets to negatively reprice for the risk that foreign revenues would be lower than anticipated.
Indeed, we have seen this happen, and I believe that such will continue in the new year, and further, I believe this will be a positive around which markets can continue to coalesce.
So, in closing, I believe that markets may have bottomed, but not necessarily the economy. I believe that markets can recover losses resulting from overly nefarious assumptions from the previous year even if the economy hasn’t yet found its bottom.
I believe that last year, when markets became very shortsighted, that overly nefarious assumptions were priced into the market with regard to economic activity. These assumptions were predicate on the thought that central bankers across the globe would follow prescribed targets of tightening without regard for evidence of economic deterioration. On many occasions last year, I suggested that I thought this belief was irrational.
Said another way, I believe that markets priced into themselves the likelihood of a very deep and a very long recession. I do believe that eventually the National Bureau of economic research will confirm that we are in a recession, but I believe it will be a shallow recession, and relatively long in duration.
So yes, I do believe that markets can continue to positively reprice for the risk that previously made assumptions went too far. That does not necessarily mean that the economy has bottomed, but I also don’t believe that this will be the kind of 2008 style recession that the market was expecting.
Frankly, there are some signs of good news on the inflation front. Recently, respondents to the ISM Manufacturing survey reported that commodities reported in short supply were declining, and commodities reported up in price were also declining. Said another way, the materials that go into the manufacturing of this pen are becoming more plentiful, and less costly. That’s good news, and I can assume that I should be able to pay a lower price for this pen in a few months.
However, the majority of inflation according to the Federal Reserve seems to be rooted in such places as food, fuel, healthcare, and shelter.
By its own admission, the Federal Reserve can do little to impact inflation at these levels with monetary policy. So yes, it will take time, but it appears that we seem to be moving in the right direction.
Having said that, at a high level, I would suggest that it would still be prudent to remain more defensively invested in companies that manufacture products and deliver services that are durable in nature, rather than have overweighted positions in companies that produce discretionary things. Said another way, invest in the companies that make the toothpaste, the shaving cream, the ibuprofen, and the food staples. At this point, I would avoid the companies that make the things that you don’t necessarily have to have. That strategy worked well last year, and I believe it will continue to be of value as the new year unfolds.
Finally, I would just like to stress that everyone should be most concerned with the fruition of planning objectives, and where they stand in relation to those objectives, more so than what the Fed said last month, or how the market might react in response. The allocation of your portfolio should not be static. It should be fluid, and reflect where we are economically, but the primary concern should be are you still moving forward toward the attainment of stated goals. When you can take this kind of holistic view, it helps a lot with the emotional management of a volatile market.
(*) David R. Guttery, RFC, RFS, CAM, is a financial advisor, and has been in practice for 31 years, and is the President of Keystone Financial Group in Trussville. David offers products and services using the following business names: Keystone Financial Group – insurance and financial services | Ameritas Investment Company, LLC (AIC), Member FINRA / SIPC – securities and investments | Ameritas Advisory Services – investment advisory services. AIC and AAS are not affiliated with Keystone Financial Group. Information provided is gathered from sources believed to be reliable; however, we cannot guarantee their accuracy. This information should not be interpreted as a recommendation to buy or sell any security. Past performance is not an indicator of future results.