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First Quarter 2022 Newsletter

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First Quarter 2022 Newsletter

Stop Asking When. Start Asking Why.

Sarah K. Charles, CSRIC™, AIF® / Director of Business Strategy

“Is now the right time to invest?”

It is one of the most common questions that investors ask as they process the various threads of geopolitical events, macro-economic trends, natural disasters, cultural phenomena, and hair-raising headlines that are woven together into the tapestry of good news, bad news and uncertainty that is the backdrop for our lives. The first quarter of 2022 – which incidentally was the worst quarter for U.S. markets in 2 years and ended a 7-quarter streak of positive returns – was especially challenging for investors because instead of a single narrative to navigate e.g., Covid OR inflation OR supply chain OR war, we were bombarded with a multitude of storylines i.e., Covid AND inflation AND supply chain AND war.    

On the first trading day of the year, the S&P 500 and the Dow both hit all-time highs. Is now the right time to invest?

Less than 3 weeks later more than 220 U.S. Large Cap companies were in bear market territory (down 20%+ off their highs) and by the end of January, the Vix (volatility index) hit its highest level in a year. Is now the right time to invest?

With Americans facing sky-high inflation (consumer price growth was up 7.9% in February – the largest 12-month increase since 1982), the Fed announced the first rate hike since 2018. Is now the right time to invest?

By the middle of February, the S&P 500 had officially entered correction territory (down 10%+ from its high). Is now the right time to invest?

On February 24 Russia invaded Ukraine and launched the largest military conflict in Europe since World War II. The assault on democracy and the ensuing humanitarian crisis were heartbreaking, and the invasion triggered everything from a massive spike in the price of key commodities like oil and wheat to the collapse of the ruble to fears of World War III. Is now the right time to invest?

The Chinese city of Shenzhen, a major tech hub and home to the 4th largest port in the world, was placed on total lockdown in early March after a Covid outbreak, adding to ongoing global supply chain issues and serving as a stark reminder that the pandemic is not yet over. Is now the right time to invest?

There was a glimmer of hope in mid-March as the S&P 500 was up over 1% for 4 consecutive days. This has only happened 4 other times (1970, 1974, 1982, and 2020), and sentiment was bullish because every time this has happened in the past, the index has been up over 20% one year later. Is now the right time to invest?

But by the end of March the 2-year/10-year yield curve – a leading economic indicator – was briefly inverted for the first time since 2019, sending a warning that we may be entering a recession soon.  Is now the right time to invest?

At its most basic, asking “is now the right time to invest?” is an attempt to time the market. Even investors who believe that market timing is futile are still prone to ask the question because at their core they do not want to lose money.  For most people losses are disproportionately more painful than equivalent gains (it’s called loss aversion in behavioral economics) which is why people spend a lot of time and energy trying to forecast the future. They think if they know what’s coming, they can avoid losing money and by extension they can avoid the pain that they expect to feel from that loss.

There are two problems with this way of thinking. First, it’s nearly impossible to avoid a sense of loss as an investor. From 1950 – 2021 the S&P 500 was down 46% of the time when looking at daily returns, so if you’re checking your portfolio every day (as many people do), you’re going to feel like you’re losing money almost half the time.  Now if you can restrain yourself and only check your portfolio once a month, you would only feel like you’re losing money 39% of the time. And if by some miracle you could hold off and check your portfolio once a year on January 1 to see how the previous year had ended, then you’d only experience a sense of loss 25% of the time. 

The only way to completely avoid feeling any loss whatsoever is to channel Rip Van Winkle and shut your eyes for at least 15 years as the S&P 500 has never had a negative 15-year, 20-year, 25-year, or 30-year period. But that’s not realistic. And the reality is, no one is immune to the disappointment of losing money – myself included. To prove the point, I checked my 401(k) this morning for the first time in ~ 3 months. While my long-term (10-year) rate of return is excellent, all I saw was that I have less money than I did three months ago, and it doesn’t feel good.

The second problem with thinking that there is a right time to invest is that not only can we not predict the future, most of the time we can’t even imagine it.  As Morgan Housel explains in The Psychology of Money:

“Nassim Taleb writes in his book, Fooled By Randomness: ‘In Pharaonic Egypt…scribes tracked the high-water mark of the Nile and used it as an estimate for a future worst-case scenario.  The same can be seen in the Fukushima nuclear reactor, which experienced a catastrophic failure in 2011 when a tsunami struck. It had been built to withstand the worst past historical earthquake, with the builders not imagining much worse – and not thinking that the worst past event had to be a surprise, as it had no precedent.’

This is not a failure of analysis. It’s a failure of imagination.  Realizing the future might not look anything like the past is a special kind of skill that is not generally looked highly upon by the financial forecasting community.”

Framing it as a failure of imagination helps put a lot of things into perspective – including historical events which frightened investors back when they happened.

Much of 1999 was spent in a panic thinking that the world as we knew it would come to an end when the clock struck midnight on December 31 and our computers would crash because of Y2K.  Is now the right time to invest?

I was at the base of the World Trade Center at 8:46am on September 11, 2001, when the first plane hit. What I witnessed that day was unfathomable and beyond the reaches of my naïve, pre-9/11 imagination. Is now the right time to invest?

In 2011, Standard & Poor’s downgraded U.S. debt for the first time since the ratings agency was founded in 1860. Even the slightest probability that we could default on our debt was inconceivable. Is now the right time to invest?

Lehman Brothers and Bear Stearns – Wall Street stalwarts now gone – victims of the Financial Crisis. Great Britain votes to leave the EU. A pandemic that brought the global economy to its knees.  Russia’s invasion of Ukraine.  None of these were imaginable until they actually happened. Some of them are still hard to comprehend.   And they all prompted investors to wonder: “is now the right time to invest?”

Exhibit 1

As Exhibit 1 illustrates, the answer is yes – every single time. Despite living in a world steeped in crisis, markets have rewarded patient and disciplined investors over time.

But this isn’t simply about the markets’ response to a crisis or how the world impacts our investments. What happens in the world also impacts us personally which is why when you invest is not nearly as important as why you invest. When was the last time you asked yourself: “Why do I invest?” Have you developed a personal investment thesis that can guide your decisions instead of reacting to the endless cycle of chaos and unpredictability that we live in?  

By focusing on why instead of when, it allows you to shift from constantly worrying about what’s wrong in the world to focusing on the things that matter most to you.  Your values. Your goals. Your purpose. Your beliefs.  And developing a personal investment thesis provides a solid foundation to anchor to no matter how often the world shocks you.   

My “why” for investing is grounded in optimism and my belief in humanity:

Money doesn’t grow on trees – it grows in markets – and I want the financial resources to live a rich and meaningful life, and to make the world a better place. I believe in people which means I believe in the power of human ingenuity and innovation to create continual opportunities that will allow my wealth to compound over time.    

Innovation. Resilience. Perseverance.  These are people’s greatest strengths. And it is people who create, grow, and lead businesses. And it’s the success of these businesses that fuels markets over time.  It helps to remind myself of that when I log in and see that my 401(k) has lost value during the last 3 months, because unfortunately, there’s no comparable chart to Exhibit 1 showcasing a series of feel-good, life-altering triumphs throughout the last 50 years. And there’s a reason. Progress is incremental.  

Did you know that in the last century, human beings have added an extra 20,000 days to their life span, effectively doubling it? It’s a reflection of the best of humanity, and yet, it’s not something we celebrate. As Steven Johnson writes in Extra Life: A Short History of Living Longer:  

“From a long-term perspective, those extra twenty thousand days should be running as a headline in every newspaper, every day. But, of course, that extra life span almost never appears on the front page of newspapers, because it is a story almost entirely free of the traditional dramatic elements that drive the news cycle. It is the story of progress in its usual form: brilliant ideas and collaborations unfolding far from the spotlight of public attention, setting in motion incremental improvements that take decades to show their true magnitude. And so the news understandably chooses to focus on the short-term fluctuations: an upcoming election, a celebrity scandal, all the surface tremors that distract us from the movement of the underlying plates. Without that long view, we forget all the threats that terrorized our great-grandparents but were transformed into nonevents or manageable conditions so mundane that most of us never think about them at all.”

Today we take things like chlorinated drinking water, sewers, antibiotics, and seat belts for granted. But these game-changing innovations that have saved hundreds of millions of lives were not a foregone conclusion and it wasn’t obvious at the time of their invention/discovery that they would literally change the course of humanity. Contaminated milk was one of the leading causes of death among infants and children in the 19th century and although Louis Pasteur discovered the process that we now know as pasteurization in 1863, it didn’t become standard practice in the US until 1915. Johnson writes:

“The lag from discovery to implementation might well have cost millions of lives around the world. The lag happened because progress is not merely the result of scientific discovery. It also requires other forces: crusading journalism, activism, politics. Science alone cannot improve the world. You also need struggle.”

Progress isn’t just incremental. It can be so painstakingly slow that we don’t even realize it’s happening, and as Johnson points out, it often goes hand in hand with struggle.   

So, the next time you start to ask: “is now the right time to invest?” stop for a moment and look inward. Remind yourself that why you invest is more important than when you invest. And remember that humans have steadily solved problems, innovated solutions, and generally made the world a better place to live since the dawn of civilization, and our never-ending ingenuity is reflected in capital markets.

Q221 Market Perspective

Bill Laird, CFA, CFP® / Chief Investment Officer

Source: Morningstar Direct
Valuation

Although why you invest is more important than when you invest, it’s still important to understand current market dynamics which are unique, but by no means present a challenge without equals. As always, our goal is to look to history to dispel the inflammatory tones of the financial media.

Valuation is an important aspect of investing as a starting point. Current headlines may drive you to the conclusion that the market is overvalued but, looking beneath the surface, the average company is trading at or below historically normal valuations. And while expensive outliers are keeping the cap-weighted S&P 500 index multiple elevated compared with longer-term averages, the equal-weighted S&P 500 index trades at just 16.3x forward EPS, which is below the pre-pandemic 5-year average of 16.6x and near its 30-year average of 15.5x.   

Exhibit 2

Exhibit 2 illustrates that the average stock in the S&P 500 is trading below its sector’s cap weighted valuation, meaning that there are a few large companies that have stretched valuations, but the average stock in the S&P is fairly valued. This is a comfortable environment for long term investors with highly diversified portfolios and it reflects a theme that we touched on last quarter: speculative excess that fueled the ascension of companies with little to no earnings during the first six months of the pandemic have ebbed, creating an environment better suited for investors following traditional investing tenets.

As you know, we tend to favor companies with lower valuation metrics relative to peers and can find those opportunities whether the market itself is expensive or not.   We’re particularly pleased when those lower multiple “value” stocks are selling at a discount to their “growth” peers which is the current case as illustrated in Exhibit 3.  

Exhibit 3

Source: FactSet, FTSE Russell, NBER, J.P. Morgan Asset Management
(Left) Growth is represented by the Russell 1000 Growth Index and Value is represented by the Russell 1000 Value Index. *Long-term averages are calculated monthly since December 1997. **Dividend yield is calculated as the next 12-month consensus dividend divided by most recent price. 
(Right) *Communication services correlation is since 3Q13 and based on backtested data by JPMAM. **Financials correlation is since 4Q09.
Guide to the Markets - U.S. Data are as of March 30, 2022.

Additionally, we construct globally diversified portfolios, and while U.S. valuations remain historically normal, in Exhibit 4 you can see that overseas valuations are currently inexpensive making them an important part of a diversified portfolio for an investor with a long timeline for investment.  

Exhibit 4

Per Bloomberg, nearly 70% of stocks outside of the U.S are trading below pre-pandemic 5-year average P/E.

Rising Interest Rates

The financial media may also lead you to the conclusion that higher interest rates will derail stock performance. Last quarter provided for significant interest rate increases from a historically low point following emergency measures put in place for the Covid pandemic. Exhibit 5 outlines that stocks can move in the same direction as yields until economic activity is eventually slowed during the latter parts of the tightening cycle. 

Exhibit 5


Source: FactSet, J.P. Morgan Asset Management. X-intercept for each data set is calculated using a quadratic regression where interest rates are the independent variable and rolling 2-year correlation of stock returns and interest rate movements is the dependent variable.
Guide to the Markets - U.S. Data are as March 30, 2022.

The U.S. 10 Year Treasury yields currently resides at 2.3%, well below the 3.6% level that more recently provides for a negative influence on stock prices.  

Additionally, as we noted last quarter, equity markets have historically experienced gains following the start of a new Fed rate hike cycle, as you can see in Exhibit 6.

Exhibit 6

April showers bring May flowers. April also brings pretty good returns as it has historically been the best month for US stocks going back to 1950 and has seen a positive return in 15 of the last 16 years.  Of course, no one knows what will happen this year, so stay focused on the reasons you chose to invest in the first place, and make sure you get outside and smell the roses in the springtime sun.

Stay safe. Stay healthy. Take care.

The information in this article should not be considered investment advice to you, nor an offer to buy or sell any securities or financial instruments. The services, or investment strategies mentioned above may not be available to, or suitable, for you. Consult a financial advisor or tax professional before implementing any investment, tax or other strategy mentioned herein. The information herein is believed accurate as of the time it is presented, and it may become inaccurate or outdated with the passage of time. Past performance does not guarantee future performance. All investments may lose money.

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