Tag Archives: Investment Management

How High Is Too High?


The S&P 500 logged a stellar first quarter of 2024, rising just over 10% in 3 months. Moreover, it has gained more than 28% since the October low, just five months ago. It is likely that something will happen to trigger a sell-off from these levels. Trying to time a correction is not a good strategy. Sometimes momentum begets momentum. We could see another 10% rise before a reversal. The price of market returns is volatility. It might help to view part of the recent gains as “cushion” to offset a correction.

We’ve Come a Long Way

I am attempting to lean into rising risk by delaying new cash deployments and allocating new funds to value oriented positions. On the positive side, the Morningstar Market Valuation indicator suggests that the market is only 4% overvalued. That does not suggest a change in strategy, but I see significant parts of the S&P 500 trading at valuations that stretch my imagination.


Valuation and concentration risks are becoming elevated, but a correction is not inevitable in the near term. The key factor, as usual, is earnings and cash flow growth that provide fundamental support for market valuations. Another moderate risk factor would be fewer or delayed rate cuts. More impactful, but less likely factors include an inflation rebound or an earnings slowdown.

The overall outlook remains positive based on the four supporting themes including:

  1. Stable growth
  2. Falling inflation
  3. Impending Fed rate cuts
  4. AI enthusiasm

I will be watching these developments.

Past performance does not indicate future performance. Investing involves risk, including loss of investing principal.

Taking Stock of the Rally

The S&P 500 finished 2023 up 24.23% (Morningstar data source). Even though the index was positive throughout the year, the volatility was challenging.

(SPY is an ETF that tracks the S&P 500. Graph illustrates SPY performance for 2023)

Expectations of lower interest rates and a soft or no landing drove the rally during the past two months. Four important assumptions underpin current expectations.

The market consensus supporting valuations includes:
1. Six rate cuts for a 1.5% cut in the discount rate, bringing the year-end fed funds rate below 4%.
2. No economic slowdown/sustained earnings growth
3. Geopolitical conflicts do not worsen.
4. Domestic political situation does not deteriorate.

These assumptions are not necessarily wrong, but they may be optimistic. The issue is how events surrounding these issues unfold.

Other observations to keep in mind as 2024 kicks off. The Magnificent 7 large cap tech stocks that comprise about 28% of the market cap weighted index (as of 12/19/2023) overshadow the S&P 500 performance. Using the S&P 500 as a benchmark is problematic in that it skews the risk/return of the broader market. I expect the market to broaden as the rest of the market plays catchup and large cap tech cools.

Investing involves risk, including the possible loss of principal. Past experience does not predict future returns. I could go and and list all the other boilerplate language that regulators like to see, but I’ll stop here. If you have any questions about anthing inferred from this post, please consult with me or another investment advisor.

1st Half Results

The first half of 2023 is behind us. The Fed’s discount rate has gone from 4.5% to 5.23%. We had 3 bank failures that heightened awareness of the vulnerability of banks that take excessive interest rate risk. Inflation has remained higher and stickier than central banks would like. The Russian war with Ukraine drags on while China threatens to invade Taiwan, potentially destroying a huge chunk of the world’s semiconductor supply. Meanwhile, the debate about hard or soft landing is tilting away from recession since the Fed’s recent pause on the next interest rate hike. Political discord continues.

Seems mostly grim. But notice that the S&P 500 was up 8.3% in the second quarter, and 15.91% year-to-date according to Morningstar. If this is what happens when things are bad, image what would happen if we could all get along?

Short-term market forecasts are subject to the vagaries of news flow and emotions. Over the long term, economic reality matters. While the recent runup feels nice, the market appears to be approaching fair value. Part of the rebound is from the discount it suffered last year when rising interest rates and surging inflation caught the market off guard. Now it appears inflation has peaked, and further interest rate increases will be modest, if they are necessary at all. The issue now is when inflation will recede to the Fed’s 2% target. Economic data will drive the Fed’s decisions as well as the market.

Recession Ahead?

Despite a banking crisis, rising interest rates, the indictment of a former president, et al., the S&P 500 finished the 1Q23 with a 7.03% gain. However, within the U.S. Market, growth stocks were up 14.79% and value was up only .18%, according to Morningstar. Despite this quarter’s gains, the Morningstar Market Valuation estimate puts the market at 92% of fair value.

The Fed kept interest rates too low for too long. There’s plenty of blame for both sides of the aisle in Congress too. While inefficiencies need to be purged from the system, politicians try to address the suffering at the individual level of those directly impacted when marginally profitable businesses are forced to close.

The banking problems that surfaced in March 2023 are one of the unintended consequences of Fed policy. Low interest rates incentivized banks to stretch for yield by buying long duration bonds that exposed their asset portfolios to excessive interest rate risk. When Silicon Valley Bank faltered, the whole banking system became suspect, and we saw a contagion effect with depositors pulling funds from similar banks. The Government intervened by extending FDIC insurance.

It is unreasonable to expect that 10+ years of easy money will not create some financial moral hazard. Now that we’re getting off the sauce, we’ll see who has been swimming naked. I expect continued volatility until the second half of the year. Getting past the peak interest rate question, lower inflation, the regional bank solvency question will likely result in better equity markets by the end of the year.

Patience

In my market outlook a year ago on January 3, 2022, I said, “I think a 20% correction would be reasonable… A 20% correction is not fun, but it is to be expected.” I’m not trying to say I told you so, but we need to maintain perspective after a very ugly year. Bonds went down too.

What now? Coming into 2022, the stock market looked about 7% overvalued. Now, it appears to be about 16% undervalued relative to Morningstar’s fair market value index. Since the end of 2010, only about 5% of the time does the market appear cheaper by this measure.

The broad landscape for investors is much healthier than it was a year ago. Valuations have come down. Interest rates are rewarding creditors for taking risk. Things are getting back to normal, and that’s good.

It might take another few quarters to see results, but the 2022 headwinds should turn into tailwinds later in 2023. The issues include slower economic growth, tightening monetary policy, hot inflation, and rising long-term interest rates. According to most projections, these issues should begin to resolve by the middle of this year.

Geopolitical risks around China, Russia, North Korea, and perhaps Iran, remain a threat to western civilization.

Heightened uncertainty makes the stock market go down and that creates an opportunity for long-term investors.

Investing involves risk, including loss of principal. Past performance is not indicative of future performance.

Closer to the Bottom than the Top

In January I said we should expect a 20% correction. I believe the Fed’s hawkish response to inflation has driven markets to over-shoot to the downside. I think the interest rate shock will slow the economy sufficiently to break the rapid rise in inflation and the Fed will pivot to a more dovish stance. We need positive real interest rates with low inflation, so stock prices can normalize. How long this take to play out is probably measured in quarters, not years.

Everyday millions of people vote on the value of companies by buying and selling. Many are influenced by the latest interview on CNBC. The only thing I know with certainty is that none of the pundits know what will happen. If watching the gut-wrenching volatility affects your happiness, you should probably spend your time watching something else. A quarterly review will tell you what you need to know.

Interest rates influence the value of stocks. Stocks are worth less with higher real interest rates than low rates. The artificially low rates we had until recently are the main reason stocks were overvalued in January.

There is a probable way out for stocks. Watch the following: Inflation will eventually recede, the Fed signals a pause, a Russia/Ukraine ceasefire occurs (which will happen at some point, even if it’s a Korean War-type solution where the war never actually ends and there’s a demilitarized zone). Then, China realizes that an economic collapse is worse than COVID and the U.K. accepts the reality that one can’t solve a problem partially caused by too much money via throwing more money at it (this already happened over the weekend – I wrote this on Friday afternoon and guess what, the markets are up about 3% mid-Monday afternoon). These things can happen, and they can happen fast. When they do, stocks should stage a massive, legitimate, well-rounded rebound.

Like Ian, I believe this storm shall pass.

Inveting involve risk, including loss of principal. Past results do not guarantee future results. The opinions expressed here are my own.

The Eye of the Storm

The first half of 2022 was ugly, but at least there are signs that the worst is behind us.

Only six times has the S&P 500 lost more than 15% in the first half of the year since 1932. The result should not be a surprise, given the headwinds facing the economy:

  1. Inflation above 8% per year (highest since 1982).
  2. Aggressive tightening by the Fed (1.5% rate increase thus far with more pending)
  3. Slowing growth expectations
  4. Rising risk of recession
  5. Persistent conflict in Ukraine

The S&P 500 officially entered a bear market on June 13, with a 20% decline from the peak. Keep in mind that the market appeared overvalued at the beginning of the year, and now looks to be about 17% undervalued. From these levels, with forward PE ratios between 16 -17x, the greatest risk to the market would be an extended recession with persistently lower earnings. Earnings moderation is priced-in, earnings collapse is not.

I believe this is a good time to add to equity investments. Short term result can vary wildly, but as the time horizon extends to 5 years or more, the chances of attractive returns increase dramatically, particularly from current valuation levels.

Higher Still?

The good news is the stock market had another great year. The S&P 500 was up 26.84% in 2021. That is on top of the 16.26% in 2020 and 28.88% in 2019. That’s quite a run, even if it started on the back of a down year in 2018.

On the other hand, the S&P 500 is overvalued by most standards. By comparison, the Vanguard Total International Stock ETF, was up only 9%. More telling is the price to earnings ratio. The S&P 500 trades for 21.15 times earnings while the non-US Vanguard ETF, VXUS, trades for 13.2 times earnings, a 37.6% relative discount. (based on Morningstar data)

If you have a diversified portfolio, your investor returns have lagged the S&P 500, where performance was driven by large cap tech stocks.

When will things reverse? I cannot say when, but I can imagine how it might happen. In the words of John Maynard Keynes, “The market can stay irrational longer than you can stay solvent,” the timing is unpredictable. The predictable factor is that it will likely require a catalyst to put the market on sounder footing.

Potential catalysts include:

  1. A worsening COVID scenario with new variants and higher case counts
  2. Persistently high inflation
  3. A Fed policy mistake (watching the yield spread between 2- and 10-year Treasuries)
  4. Slowing earnings growth as Fed stimulus recedes.

If one or more of these events occur and earnings expectations decline, I think a 20% correction would be reasonable. The math of a 4% decline in earnings and an 18 P/E multiple fits such a scenario. But things can go right too, so timing a correction is not a sound strategy.

The prudent course is to plan for liquidity needs and maintain a diversified portfolio and perhaps more cash than usual. Think of cash as an option to buy stocks cheaper if they go down. A 20% correction is not fun, but it is to be expected. When it happens, a little cash goes a long way. One more thing… when the market goes down 20%, you only lose 20% if you sell low. The bigger issue is how long it takes to recover. It has always recovered. Whatever you do, don’t sell low

Press On

Last year we wondered about the biggest risk to the markets. Was it the threat of persistent low-interest rates and the implied inflation threat, Government budget deficits, tax hikes, or valuations? Media and headlines covered pundits’ messages illustrating what could go wrong.

In retrospect, none of that mattered. The problem was something no one talked about because no one knew about it. A virus-induced pandemic ensued and led to a shutdown of large parts of the economy.

The important takeaway is that the greatest risk might be what you do not see coming. If you are not aware, it is hard to prepare. However, I will point out one more time that I covered the bases by listing plagues among several caveats to my sanguine outlook.

Like earthquakes in California, you know they will happen. You will not know when. In the stock market, we seem to have a big one, a 40 to 50% decline, about once every 10 years. We also average about two recessions every 10 years. Despite dramatic declines, the long-term trend continues up as billions of people around the world get up every morning to do something productive to improve their lives.

I do not know when the market will go down, but history shows that it always comes back. Most of the time recoveries occur within a few years if not months. Some risks are more apparent than others. But for whatever the reason for a correction, the important thing is to avoid selling into a distressed market.

Source Yahoo Finance, S&P 500 Total Return 1/1928 to 1/2021, Monthly, Log Scale

Planning requires anticipating how much money you are likely to need from your portfolio and reducing risk in part of your portfolio to reduce your potential need to sell in a distressed stock market.

Now what about 2021? The 5 key drivers of current market strength include Federal fiscal stimulus, vaccine rollout, divided government, dovish monetary policy, and no double-dip recession. Each of these factors favor continued gains, but none is certain. Near term, I can make the case that the market is on the expensive side. I do not think the options (cash, bonds, hard assets, real estate) are more attractive on a risk-adjusted basis.

As Calvin Coolidge observed, “Nothing in this world can take the place of persistence. Talent will not; nothing is more common than unsuccessful men with talent. Genius will not; unrewarded genius is almost a proverb. Education will not; the world is full of educated derelicts. Persistence and determination alone are omnipotent. The slogan Press On! has solved and always will solve the problems of the human race.” I remain focused on long-term value creation.

With 2020 behind us, we’ll press on.

Investing involves risk, including loss of principal. Past performance does not guarantee future returns.