Constant Change vs. Chaos

Constant Change vs. Chaos

When tough times hit and emotions rise, things can feel like chaos and people will take extraordinary, and in hindsight often foolish steps to try to mitigate their environment. But there is an important difference between chaos and the ever-present reality of constant change. We discuss what that is, and why it is so important for successful investing.

Five Things You Should Know

1. Equity Markets – were higher this week with U.S. stocks (S&P 500) up 6.58% while international stocks (EAFE) rose 3.72%.
2. Fixed Income Markets – were higher with investment grade bonds (AGG) up 0.70% while high yield bonds (JNK) rose 1.10%.
3. Fed Talks Recession – this week saw Fed Chair Powell answer questions from congress, most notably acknowledging that a recession is “certainly a possibility”, but that the central bank is “strongly committed” to bringing down inflation and remain confidence in their ability to do so without creating additional concerns to the U.S. economy. Powell pointed to both a strong labor market and high demand as signs that economic conditions are still generally favorable.
4. Housing Cools – With mortgage rates now hovering around 6%, a 15-year peak, the national housing market looks to finally be slowing down with a recent ranking by Bloomberg placing the USA #7 in the world for “at-risk” property markets. New home sales took a noticeable hit this month while existing sales fell to a 2-year low.
5. Key Insight – [VIDEO] When tough times hit, and emotions rise, things can feel like chaos and people will take extraordinary, and in hindsight often foolish steps to try to mitigate their environment. But there is an important difference between chaos and the ever-present reality of constant change. We discuss what that is, and why it is so important for successful investing. [ARTICLE] The stock market keeps making history in all the wrong ways. Is it unprecedented? Does it mean even more heartache and losses are on the horizon? We discuss how historical precedents and even some shocking current statistics would argue otherwise.

Insights for Investors

“When a stock goes down, they say the stock is telling them something you know. What it is telling me is I can get more for my money.” – Warren Buffett

Most weeks I sit down to pen these and have no real idea what I’ll talk about it. In the past there were week’s that were close to paralyzing, but in recent times I’ve learned to simply reflect on all the conversations I’ve had throughout the week and use those as inspiration.

Consequently, while it may seem like I have a bias of my own or pre-set agenda, the truth is more times than not I simply want to provide another perspective to counter the common prevailing narratives of the day.

For the majority of last few years (in some ways 10+) that meant cautioning investors around being too optimistic around future returns, the perceived invincibility of tech stocks, or continuing to hold on to their bonds that had just soared after the COVID crash. We even told you that it was time to let go of the beloved traditional 60/40 and consider a new approach to counter what we believe would be unprecedented times (see here 8/7/2020).

Clearly of late, the overwhelming investor sentiment and outlook, and of course that of the ever-present downer that is the financial press, had been historically awful with the most followed study on it (sentiment) by AAII hitting all-time lows of bullishness and double the historic averages of bearishness.

At such times its easy, and quite natural, to feel as though they will never end and that recent losses could only indicate the coming of more losses.

As is often the case, history and a less emotional look at the facts tells us something quite different.


The Danger of Trading Based on One’s Recency Bias

As of last week’s close, the S&P 500 was down 23% year-to-date and 19% this quarter alone. It is of course very common for people’s “recency bias” to kick in at such times, and as pessimism grows, to believe the market will fall forever. When looking too much into the price action of stocks Warren Buffet has been quoted saying, “…there is nothing about the price action of a stock that tells you whether you should keep owning it. What tells you whether you should keep owning it, is what you expect the company to do in the future”.

Put another way, keep perspective and know why you bought a position to begin with.

On the issue of recency bias and investors belief that recent price action of an investment is indicative of its future, the folks at Bespoke highlighted some interesting facts to show just how wrong this common mindset trap is.
They noted, “…the S&P 500 is on pace to experience its 9th quarterly decline of 15%+ in the post-WW2 market era. Following the prior 8 quarterly drops of 15%+, the S&P averaged a gain of 6.22% the following quarter, a gain of 15.15% over the next two quarters, and a gain of 26% over the next year. Over both the next half year and year, the index was higher every single time. The S&P is also down 23% in the first half of 2022. Forward returns following prior two-quarter drops of 20% or more are similarly bullish. Every time the S&P has fallen 20%+ over any two-quarter period since WW2, the index has been up at least 22% over the next year (or next four quarters)”.

They went on to note that the last couple of weeks, ending June 17^th, have also made history in that, “In the post-WWII period, there have only been seven other periods where the S&P 500 declined 5%+ in back-to-back weeks with the last occurrence transpiring into the lows of the COVID crash … If you're familiar with market history, you'll immediately notice that these streaks occurred during some of the most tumultuous periods in market history - August 1974 (Nixon Resignation), October 1987 (Stock Market Crash), September 1998 (Russia Default, Long-Term Capital Management), July 2002 (Dotcom Bust), October and November 2008 (Financial Crisis), March 2020 (COVID Crash), and now (the 60/40 Crash) … The only time the S&P 500 continued to trade lower was in October 1987 when on the following Monday, the S&P 500 dropped more than 20%. Six and twelve months after each of the six other periods, the S&P 500 was higher every time”.

Whether one wants to consider the average return 12 months later after a full 20% decline (22.2%), after a quarter with a drop of 15% (26.07%), or after two weeks such as we just endured (28.16%), the point is if you truly want to know what is most probable it is that the market will likely surprise to the upside and do so with vigor. A quick look at the chart below shows you that selling at the red dots would have “felt” right but been very regrettable in short order.

Market at Traditionally Attractive Levels

When you study markets long enough you realize there is a gravity to things, and therefore a real power in mean reversion when things get too extended to either side of that “zero line”. Such an understanding doesn’t allow you to time markets or predict just how “extended” things can get in either direction. However, for an investor with discipline and patience it can tell you when you are likely making a decision that you will feel good about it time.

One of the items that can help you determine where markets are at within the big picture was recently discussed by respected market commentator Brian Gilmartin. He noted that the current earnings yield of the market would suggest that we are reaching very attractive longer-term entry points. Despite the bearishness pervading seemingly all media and investor mindsets, he said, “…the forward earnings estimate (of the S&P 500) jumped to $236 from last week’s $235.61”, bringing the earnings yields to, “6.42% from … 2022’s start of 4.77%”.

Investopedia defines earnings yield as, “the earnings per share for the most recent 12-month period divided by the current market price per share. The earnings yield (the inverse of the P/E ratio) shows the percentage of a company's earnings per share”.

The reason many follow this metric is that historically when the earnings yield’s moves to a level significantly higher than the 10-year Treasury yield it has indicated an attractive entry point for patient investors. Current 10-year yields are around 3.20% or HALF of the current S&P 500 earnings yield meaning the market is likely signaling strong value for patient investors as lending quantitative support to the historically reversions pointed out by Bespoke above.


Cash is King

Many investors have likely asked themselves recently, “should I go to cash?”. Truth is the average American is already sitting on a ton of cash.

While near term the stock market can take any number of paths, for those with an actual investing (as opposed to gambling/speculative) mindset that are looking at least 6-12 months out (as opposed to 6-12 days), there is good reason to believe the economy can make it through, and even if a recession were to occur it likely would be mild – and consequently largely priced into risk markets at today’s prices.

Put as succinctly as I can, it is hard to believe a recession is imminent or likely to be severe when one looks closer at corporate and personal balance sheets – and yet the stock market seems to have already priced one in. It would bend/break most understandings of basic economics, current understandings of what creates/created severe recessions/depressions, and actual current spending data to not think current cash levels matter.

Consider the following:

1. Credit card debt is lower today than before the pandemic and at a 20-year low as a percentage of total debt;
2. Consumers saved approximately $2.6 trillion during the last two years, the majority of which is not held by the upper class, bringing excess cash in checking accounts to $3 trillion above trend;
3. Wage growth is north of 5% and almost 7% for the lowest earners (the most at risk from inflation).

Further evidence of financial strength can be seen in the chart below highlighting the continued resilience of dividend payments and share paybacks. For clients of TEN positioned in many of these types of stocks, this is yet another reason to rest a little easier.

As First Trust made a point to note about the chart above, “Keep in mind that, from 3/31/20-3/31/22, S&P 500 Index companies spent $1.5 trillion on stock buybacks and another $1.0 trillion on dividends, yet they hold the same amount of cash today as they did on 3/31/20”.


In Closing

I take the time to write these each week to hopefully keep us all in a more balanced and logical frame of mind (and that absolutely includes myself too!!).

It forces all of us to ask what is true, what do we actually know, what is most probable, what are we really trying to accomplish, and what is reasonable to expect on the journey to that destination?

I don’t pretend to be able to predict the future in general, let alone the near-term moves of a stock market largely driven by human emotions. However, there are some truths and patterns that take shape throughout history when given time, and that is where I keep my focus.

Bear markets generally take three forms and/or have three phases: 1) Liquidity crashes – economic shock (2020), valuations led (2000/2022), 2) Imminent Recession Fears – Fed induced hard landings, and 3) Credit Crisis’ – 1928 and 2008.

We’ve had some degree of number one, seem to be in the middle of #2 and likely to have fully priced in a recession from a fundamental (if not fear) perspective, and the third phase/type I would argue is unlikely to occur anytime soon given the cash on hand that we discussed above.

All that is to say, while it may seem very dark at the moment there is good reason to believe the dawn isn’t too far off.


Have a wonderful summer (finally!!) weekend,

Tim and the team at TEN Capital

Data, Just the Data

Data points this week included:

• U.S. Jobless Claims – remained somewhat steady from the week previous, only decreasing by 2K to a claimant count of 229K for the week ending June 18^th. Labor markets remain tight, and the four-week moving average moved up to 223.5K.
• U.S. Consumer Sentiment – the Univ. of Michigan consumer sentiment reading fell to an all-time-record low of 50.0 for the month of June. Consumers are the most bearish they have been and 79% of consumers expect ‘bad times’ for business conditions – the most since 2009.
• U.S. New Home Sales – increased 10.7% MoM to an annually adjusted rate of 696K in May and well above market expectations of 588K. Elevated home prices, and mortgage rates now touching 6% will likely put downward pressure on June home sales. Last month’s median sales price of a new home was $449K, an increase of 15% from last year.
• U.S. Existing Home Sales – fell by (3.4%) MoM, to an annually adjusted rate of 5.41M in May – this is the lowest reading since June 2020. Sales fell for the fourth consecutive month with high inflation and mortgage rates carving out household income. Inventory rose 12.6% and the median existing home price was $407K – an increase of 14.8% from a year ago.
• U.S. PMI Composite Flash – declined to a 5-month low of 51.2 in the month of June, which was a slight decrease from a 53.6 reading in May. This was the second weakest output in activity since July 2020 as the service sector slowed, and manufacturing has contracted for the first time in two years.
• U.K. CPI – the inflation rate bumped up to 9.1% in the month of May and logged the highest rate since 1982. Housing and utilities jumped up 19.4%, household goods rose 10.5%, while restaurants and hotels moved up 7.6%. MoM, consumer prices rose 0.7%.