Investors are not happy with the current phase of the market, which could be labeled a transition starting in late 2021 or January of ’22.
We left a stimulated expansion and rising US stock market for a contracting “bear market” and likely economic recession.
The stock market performed its traditional function by discounting the future and falling before an economic contraction began.
The Federal Reserve was on its original mission, performing the function that it is perhaps best suited to accomplish, the protection of the banking system. (One can question the wisdom of assigning other responsibilities to the Fed.)
The Fed has learned that banks should have balance sheets assuring their survival in potential economic contractions. The Fed consequently required banks to show they could survive possible severe economic conditions, without necessarily predicting them.
The tool used created very severe stress tests. The way the Fed used these tests limited the bank’s commitment to expansion and dividend increases. All banks passed the minimum requirement in the last stress test, although JP Morgan Chase and Citi were refused permission to immediately raise their dividend.
Many were shocked that JP Morgan was not given permission to raise its dividend. Afterall, the country’s largest bank had styled itself a fortress to defend its depositors from major problems. (Including ourselves) From the Fed’s perspective the bank was expanding too fast, especially if a very serious economic contraction materialized.
Surviving investors learn from changing conditions and I am now applying stress tests to how I manage money for clients and my family.
How deep and long a decline
Applying an overly stringent set of filters to the oncoming contraction is creating stress for me and our accounts. Over the last two weeks the US and Chinese stock markets rose, while bond credits and commodities declined. A rise in stock prices is normal during bear market rallies on below average volume.
The decline in the other asset types is worrisome, as they tend to be owned by more risk aware investors. In general, these asset types generate less capital appreciation than the average stock and are time constrained. Stock investors often view moves within the fixed income and commodities markets as warnings for the stock market.
An offset to this bearish picture is to remember that falling prices and low volume should be viewed as an opportunity. Howard Marks, an old data client and a very successful investor is quoted as saying “Today, I am starting to behave aggressively”.
Picking the highest performing strategy at the exact right time will produce great results, but good luck achieving that.
For prudent risk-aware investors, a more comfortable strategy is the right combination of a limited number of strategies. This is an artform that great portfolio managers demonstrate most of the time.
My personal stress test perceives the adoption of at least five logical strategies as we exit this interregnum phase.
- There have only been a small number of bear markets without a follow-on recession. One example is the Fed’s gigantic growth of money supply during the Trump period. It came so fast that a “value investor” like Warren Buffett did not have the opportunity to buy large amounts of good companies at fair prices.
- In a “normal” cyclical recovery, asset prices for stocks drop to sounder levels as probable results are discounted.
- Structural recessions usually address economic imbalances through the liquidation of debt, which often requires a well-known financial player to collapse in some financial crisis. Currently, the largest debtor relative to revenues is the US government. (The obligations of the US government are materially greater than its tax revenues, leading to increased levels of deficits.)
- A depression is triggered by the political establishment policy mistakes intended to solve short-term problems requiring deep social restructuring. A classic example was the tax and tariff policies of the late 1920s, followed by the radical restructuring attempts in the 1930s. This turned a 5-year cyclical recession into a 10-year depression.
- Stagflation occurs in a period of slow revenue growth combined with high inflation and unwise regulation. We suffered such a period in the 1973–1982-time frame.
The five strategies listed are in rough order of the shortest expected lapsed time in a bear market without a recession, and the longest stagflation. Another critical time scale is your expected investment period.
For the longest periods, eg, a grandchild’s college endowment, very little in the way of reserves are needed. More reserves are needed to offset potential losses due to unfortunate timing in short time periods.
Over extended periods, the aggregate performance of “growth” and “value” are about equal. However, there are two main differences in the selection process; tolerance for volatility and how the main financial screens are utilized.
Growth investments tend to be volatile based on news. You consequently need to pay intense attention to any element impacting the income statement, particularly net cash generation excluding all uses of cash or buying power.
Value investments appear less frequently in the media and thus tend to be less volatile. This is particularly true if they pay a regular dividend, which is hopefully growing. The adjusted balance sheet is the most important document in their selection and includes the current pricing of all assets and liabilities.
Additionally, the value of people, customers, brand name, patents/copyrights, or under-utilized resources need to be added. You need to add all reasonable contingencies, including the shut down costs of work sites and people. In many cases, a forensic accountant and bankruptcy lawyer is needed.
The main reason this blog is titled “Stress Test” is that there are currently “green shoots” of positive information as well as disappointing signs.
Reasonable analysts may disagree on both the importance and characterization of listed items in the proper category. Interesting, I pay attention to all as possible signals of things to come.
I welcome all views that agree and disagree the view expressed.
- The JOC-ECRI Industrial Price Index weekly change was -2.47%
- The AAII 6-month bearish view was 46.7%, vs 59.3% the prior week. (This was a move back from a very extreme position the prior two weeks, viewed by market analysts as a contrarian indicator.)
- Copper prices are recovering from a high price in April due to rising Chinese demand.
- In last 3 months, M-2 money supply growth was only 0.08%.
- Fed funds futures prices are dropping.
- The bond market appears to be capitulating,
- The combination of China producing both a hypersonic stealth bomber and a 4th generation aircraft carrier, should be good for defense spending.
- According to the American Farm Bureau annual survey, the cost of a July 4th picnic has risen 17% in the past year to $69.68.
- Tech companies, among others, are laying off workers.
- The Atlanta Fed is forecasting a second quarter contraction of 1%.
- I wonder how much of the relatively low trading volume on Friday was short-covering before the long weekend.
- The claim that the market is priced more attractively now than earlier in the year looks questionable, as pundits are using current prices and what I believe to be “stale” earnings estimates. The severe drop in June sales may have led to considerable write-downs of inventories and prices.
A former president of the New York Society for Security Analysts, Michael Lipper was president of Lipper Analytical Services, the home of the global array of Lipper indices, averages and performance analyses for mutual funds. His blog can be found here.
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