We hope these comments find you healthy and well and provide some explanation of the current market conditions and what we are doing to navigate these rapidly evolving dislocations.
After the stock markets rallied back about 8% in March after the initial selloff in January and February, the “bears” have found their strength, and the selloff continued giving us extreme bouts of volatility. This has accelerated thus far in May reaching virtually all asset classes (stocks, bonds, national real estate, and cryptocurrencies). Year-to-date both stocks and bonds have seen steep moves to the downside.
Year-To-Date Asset Market Recap
|Stock Indices: |
Dow Jones: -12%
S&P 500: -17%
Russell 2000: -20%
Emerging Markets: -20%
International Developed MSCI ACWI Ex US: -17%
20+ year U.S. Treasury Bonds: – 22%
Intermediate Bonds: -12%
Short Term Bonds: -5%
|With the Fed poised to raise much higher over the next 6 months, the volatility is likely to continue, and conditions could potentially get worse. Our last update talked about how the S&P 500 was overvalued from a price and earnings standpoint, and bonds have fallen as much as stocks when they are historically supposed to do the opposite. Quick reminder, we sold all our long bonds in October of 2020 and the rest by February 2021. This has helped us tremendously as long-duration bonds are down over 20% just this year and even intermediate are down 12% YTD. |
In addition to the bond sales, late last year we continued to build cash positions across the portfolios by lowering equities in August and October, then again in January of this year. We have added hedges that are not dependent on interest rates or economic activity but even with playing strong defense, our portfolios are down year-to-date.
As the market summary above shows, the year-to-date performance on the Nasdaq is down 27%, small and mid-cap stocks are down about 20% and international is pushing -20%. The bright spot is the S&P 500 due to its value exposure is down 17% and this is where the majority of our stock exposure comes from. This along with no bond exposure has allowed us to outperform markets year to date quite handily, though still negative.
I still believe these market conditions could get worse before they get better with continued high volatility over the next 3-6 months. We recently sold another 5-10% of equities believing markets are in the middle of trying to price in the next moves by the Federal Reserve, sustained high gas and oil prices, the Geopolitical risk to markets due to Russia and Ukraine as well as continued global Covid shutdowns in places like China.
In our estimation, markets have not priced in a recession yet but that is an increasing probability, so we have decided to take an even more conservative approach for the short term. Our cash allocation is much higher than we would normally have it from as low as 5% to as high as 30+% depending on allocation. We are using cash as a primary hedge in the portfolio as normal hedges like bonds are losing money similar to stocks which will continue as the Fed continues to raise interest rates. We believe the markets will eventually price in an additional 1-2% increase in the Fed Funds Rate from where they are today which means additional steep losses in bonds are likely.
|Having said all of this we do not want to be too conservative knowing markets are pricing where things are going in 12 months not where they are today. We believe the Fed will be forced to start lowering rates around this time next year and bonds and stocks will both rally, potentially starting the next bull market. It’s hard to time the inflection point but for this reason, we have lowered our equity exposure from traditional levels knowing much higher rates are on the way, plus Quantitative Tightening by the Fed will soon begin which pulls money out of the current supply.|
Since 2008 every time the markets got into trouble for a variety of reasons the answer was for the Fed to come to the rescue by lowering interest rates and printing extreme amounts of money in the form of Quantitative Easing. This action in tandem with other Central Banks has quadrupled global money supply within the last decade alone. Outside of 5 weeks in February and March of 2020, we’ve been in a bull market since 2008, but the Fed can’t help markets this time because of inflation.
The Fed truly has one problem right now and it’s reigning in inflation. Inflation can be a beast that has a mind of its own if it’s not controlled. Once pricing expectations take hold it’s very difficult to slow down price increases without slamming the brakes on the broader economy. Companies are quick to increase their prices but slow to bring them back down and unfortunately, we do not see an end to elevated energy and food prices over the next year.
With fertilizer prices up over 200% so far this year and grain up even more, farmers could be forced to use less, and rotate crops to use the same fields which means fewer nutrients and smaller yields. This could lead to food-based inflation remaining elevated for all planting seasons this year and into the 1st half of 2023. Energy and food are always the most volatile areas in any inflation reading which is why the Fed uses a core inflation number that excludes these items. Core inflation fell a bit in April to 6.14% from 6.47% in March which is still higher than the long-term average of 3.64% and up from 2.96% just one year earlier. Markets will be watching the monthly inflation numbers like a hawk (as will the Fed) to gauge their path for continued interest rate hikes and when to stop.
We believe the Fed will raise another .50% at each of their next two meetings assuming inflation is slowly backing off, then move back to .25% moves until they are done.
Even though it sounds like so much negativity we do not believe this will be an era of hyper or even extended inflation. Supply chain issues that arose globally due to Covid are being worked through and we believe by the end of this year should reduce inflation by 1-2% regardless of what the Fed does. Once the Fed has slowed the economy down enough and started to reduce the money supply, there will be an inflection point where both stocks and bonds will rally at the same time due to expectations of lower interest rates and looser monetary policy going forward.
We do not know when this will happen exactly but do not want to be so conservative as to miss out on the initial run-up knowing big gains usually happen in a very short period of time. We do not see the violent reversal to the upside in stock prices that we saw in March/April of 2020 but still want to have equity exposure, just reduced from normal levels.
Depending on your financial objectives, tolerance for risk, and account-specific permissions, Bauer Wealth models are currently allocated in the following manner:
- 20 – 40% Total U.S. Stock Market
- 0 – 10% Individual Alpha Stocks
- 7.5 – 13.5% U.S. Blue-Chip Growth Stocks
- 2.5 – 4.5% Global Healthcare Stocks
- 7.5 – 13.5% U.S. Small-Cap Stocks
- 7.5 – 15% Developed International Stocks
- 2 – 4.5% Emerging Market Stocks
- 2- 6% Commodities
- 3.5 – 17.5% Deep Buffered S&P 500
- 3- 15% Structured Notes
- 5 – 31.8% Cash
Please log into your mobile Bauer Wealth App or Desktop portal to see your current allocation.
We understand how unnerving it can be when markets are volatile, especially to the downside. We always talk about managing risk and these are the types of markets where managing risk becomes paramount. We are here to discuss your financial situation anytime and look forward to seeing all of you again soon. We thank you for your continued faith in our firm and endeavor to provide the type of service and management many of you have come to expect over the years.