Economic Update

• In some respects, the extreme lack of volatility coupled with steadily increasing share values was a greater abnormality than this correction. Stocks have been rising for many months now and, while earnings have not been especially weak, the rise in share values has substantially outpaced earnings. Most of the increase in stock values, therefore, has come from expanding multiples.
• The total return for the S&P 500 over the past year exceeds 20%, so that index could experience a full correction and still be meaningfully positive over the past 12 months.
• The proximate cause of the current selloff appears to be the employment report released on Friday, August 2. While that report showed an increase of 114,000 jobs, the result was disappointing relative to recent additions to payrolls. Unemployment ticked up to 4.3%, the highest it has been since November 2021.
• The market runup, as well as the current reversal, has been exacerbated by leveraged global trades that have been exploiting differences in borrowing costs around the world.  Large funds that could borrow cheaply in Japan and Switzerland have helped sustain the bull market in the US. Some of those “carry trades” have suddenly turned unprofitable.  Strategies that use leverage can produce outsized moves when they fall apart.
• The unemployment rate now satisfies the “Sahm Rule” for predicting recessions. That rule is based not on the absolute level of unemployment, but on the scope of its increase from its previous low.
• Many analysts have been focused on an expected “soft landing.” However, we cannot rule out some type of recession in the next several months. That’s because the type of demand destruction required to quell inflation frequently entails a meaningful slowdown in growth.
• While we do see vulnerabilities in the current economic environment, we don’t see anything like the excesses that triggered the meltdown in real estate markets prior to the financial crisis of 2008.
• Given the lagged effect of monetary policy, many of the rate increases of the past two years are just now having their full impact on the economy.
• While the advance estimate of second-quarter GDP came in at a robust 2.8%, that measure is backward-looking. Many of the more recent indicators of economic growth indicate that the economy is growing, but at a slowing rate. Recent results from the manufacturing sector and construction spending were both lower than expected.
• Late summer and fall are historically the most volatile times in the market calendar. This tends to be the season when investors and business leaders are forced to reconcile expectations with actual results.
• Both the stock and the bond market participants are trying to sort out the Fed’s next moves and the impact of domestic and geopolitical uncertainty. The US economy is transitioning from a high-growth, high-inflation economy to one where both growth and inflation are moderating. While it may be tempting to try to anticipate specific outcomes during periods of volatility, investors are usually better served by sticking to strategies that are designed to deliver acceptable returns in a wide spectrum of different environments. Our ability to design resilient portfolios is much greater than our ability to predict specific future outcomes. 

While it is not our practice to shift allocations between major asset classes, we do regularly review portfolios to protect against market excesses, to the extent possible within our clients’ objectives. In this environment, we have been careful to maintain our rebalancing schedules. We have also diversified equity positions even as the broad indexes became dominated by a short list of mega-cap technology stocks (the magnificent 7). Where appropriate, we have rotated out of ultra-short duration positions in bond portfolios and invested the proceeds in intermediate bonds or bond funds in anticipation of a lower rate environment. We have maintained our allocations to those managers who have proven to be adept at protecting value in down markets.Some themes we emphasize through turbulent markets:Doubt the forecast, trust the plan. The ability of experts and other commentators to forecast markets is extremely weak. Being honest about what we don’t know can be a strength. Go back to late 2019 and search for forecasts that mentioned a global pandemic, a market crash, 10% unemployment, and a sharp recession followed by a bull market. You won’t find one. The best time to invest is sometimes when the news is at its worst.  Most investors embark on their investment journey with a plan. That plan includes financial objectives and a time horizon. Most importantly, it incorporates an understanding of the investor’s ability and willingness to accept risk in pursuit of their objectives. When properly developed, the plan keeps the investor and his or her priorities at the center of the planning process, not market forecasts or assumptions about tomorrow’s headlines. When properly implemented through asset allocation, the resulting portfolio incorporates a required level of defensive strategies to survive negative markets, as well as a sufficient level of risk to capitalize on growth opportunities. In this way, a good plan anticipates both good news and bad without trying to predict the timing of either. Reacting to unpredictable markets and headlines can sabotage the balanced elements of a good plan.Diversification—the only free lunch. The discipline of diversification helps investors avoid the risks associated with investment in a single firm, a single industry, or even a single country. It is not a panacea. A diversified portfolio will always provide an overall return lower than its highest-returning asset, but higher than its worst-performing asset. Over time, a diversified portfolio can produce superior risk-adjusted returns with greater consistency and at an overall pace of growth that will support the investor’s objectives. Volatility in markets often widens the disparity between winners and losers, thereby increasing the temptation to bet more heavily on assets that profit from bad news. However, the next headline can reverse a trend, and diversified portfolios have exposure to assets that do well in a wide variety of environments.A sharp crisis can cause even diversified assets to converge on a negative return. However, crises, by their nature, tend to be short-lived. Like so many investment strategies, diversification needs time to deliver its benefits.Cushion with cash. Every investment plan should incorporate a cash reserve held outside of markets.  For most households, a reasonable cash reserve should equal six to twelve months’ worth of expenses.  The reserve should include amounts set aside for a known outlay scheduled to be made during the next twelve months such as a new car or the down payment on a house. A proper cash reserve will help avoid a forced liquidation of securities during a time when prices are weak. In this way, it plays an essential role in ensuring that a properly constructed investment portfolio can perform in the long run. All well-constructed portfolios are based on allocations that incorporate assumptions about long-term returns, volatility, and correlations between asset classes. In order to perform to expectations, they have to be in place long enough to deliver the intended results. A cash reserve allows investment portfolios to have a “long run.”Average in. If you’re committing new funds to an investment program or using investments as a long-term savings strategy, consider dollar cost averaging—committing a set amount at a set interval over time. Strategies like this give you more entry points and more opportunities to purchase assets at favorable prices, which can average down costs over time. It also has many of the advantages of discipline built into a simple process. It can increase transaction costs where those are a part of the investment process, but it can also reduce the risk that investment at a single point in time may be followed by adverse markets. That effect is typically mitigated by the passage of time. Negative investment returns on diversified portfolios occur more frequently in short time spans than over multi-year periods.See beyond. Rough markets don’t last forever, although it can seem that way when we are in them. The first decades of this century have included the aftermath of the bursting of the “dotcom” bubble, a global financial crisis, and a pandemic. We got through all that. On average, stocks have delivered positive returns in seven of every ten years. Those are pretty good odds.

“The big money is not in the buying or the selling, but in the waiting.”   - Charlie Munger

As always, if we can help you along your financial journey, please don’t hesitate to reach out to us.