NWP Monthly Digest | July 2022
The city of Denver is on top of the world, and the mountain of euphoria is 5,280 feet high. For the first time in fifty years, both the Stanley Cup Champion (Colorado Avalanche) and the NCAA Men's Hockey Champion (Denver Pioneers) reside in the same city. As Denver celebrated historic victories during the Colorado Avalanche Stanley Cup Parade, the stock market slid to wrap up the worst first half of the year since 1970.
The summer entertainment doesn’t stop there. House of Dragon, the prequel to Game of Thrones will be released next month. Yes - winter is coming once again as the Fed tightens policy amid a rapid rise in inflation and eroding consumer confidence. The Fed maintains its willingness to tighten financial conditions despite the calamitous prospect of causing a recession. In 2019, I wrote a newsletter as we entered the final season of Game of Thrones. The graphic I used in that newsletter seems just as relevant today.
It can be difficult for investors to parse through the headlines for useful strategies during volatile times. The first step to help you sleep at night and figure out a game plan is to spot the bulls**t….
Bulls**t
Publicly accessible information is at a point that would have seemed unfathomable 10 or 20 years ago. What used to be hidden is now free and abundant, from financial information to global news to insight into how millions of people live on social media. Bulls**t spread like wildfire on matters with undue complexity. The U.S. constitution is 7,591 words and the tax code has over 11 million words! It's easy for people to spread misinformation on these topics as spot-checking facts may be untenable.
Bulls**t comes in many forms but predicting the impossible is the quintessential form of bulls**t. Nobody can predict stock market returns or the specific path the stock market will take from here. For those reasons, it would be wise to limit your sources for investment to those you know are credible and have your best interest in mind.
For your hard-earned money, I am cognizant of the shortfalls when it comes to prophesizing the stock market. Specific predictions like the level of the S&P 500 when the market bottoms, or quarterly earnings for the S&P 500 in the third quarter are a fool's errand. However, it's possible to make broad observations with a fair degree of confidence so you are not led astray.
Dead Cat Bounce
Over the past month, I have told clients trends in the stock market could resemble a dead cat bounce or a bear market rally. In other words, a brief recovery in a declining stock market. Investors sold on the news when the stock market fell as Russia invaded Ukraine, but stock market fundamentals remained intact. I did not think it was a bear market rally at that time. But investing teaches humility and the market began to fall at the end of March as the Fed tightened financial conditions and investors reacted to hot inflation readings. Today, the fundamentals are fragile, making the prospect of a further drop in the stock market plausible.
Since 1929, the S&P 500 has experienced more than two dozen bear markets. Among the past ten bear markets, only the 1987, 2009, and 2020 versions took fewer trading days to achieve a 20% drop. This year's declines have marked a quicker-than-average descent into bear territory, at 111 trading days since the index's record high on January 3rd (Dow Jones Market Data).
The S&P 500's average bear market peak-to-trough decline has been almost 36%, and the index has taken a median of 52 trading days to bottom out after entering a bear market. That would put the bottom in roughly late August. These are only averages but the data suggests the market could sink further. The fastest inflation in four decades, an aggressive Fed, and a stock market tumble are all things that would generally presage an economic downturn.
"My judgment isn't about the competence of the Fed. It's a judgment about the difficulty of the task. The discouraging fact is that, when you have unemployment below 4% and inflation above 4%, a recession always follows within two years." - Larry Summers
Even though many indicators point to a downturn, a catastrophic fall like The Financial Crisis or The Great Depression is unlikely. The stock market is also significantly oversold. Therefore, a short-term bounce is a strong possibility.
What to Do?
Now that we've identified the information that isn't bulls**t and established the likelihood of an economic downturn, I'm sure you're thinking to yourself, now what? During times of uncertainty and stress, it is typical to let your emotions get the best of you. Instead, I hope you come away with the understanding that an economic downturn can be a rare opportunity. The two strategies that can be utilized are investing cash and increasing risk.
Investors sitting on a pile of cash should consider investing around half today. I'm sure you're thinking I'm crazy to suggest putting more money in the market right now, but let me explain. Empirical evidence suggests investors have a solid batting average with this strategy. Even though no two bear markets are alike, we can learn valuable information from analyzing the trends over time. The most important fact to remember is the slightly longer-term S&P 500 returns after a bear market closes are quite positive. In bear markets since 1950, the index has been higher 75% of the time three months later, by an average of 6.4%. A year after falling into a bear market, the S&P 500 has been positive 75% of the time, climbing 17% on average. When the S&P 500 fell at least 15% during the first six months of the year, as it did in 1932, 1939, 1940, 1962 and 1970, it rose an average of 24% in the second half (Dow Jones Market Data).
In other words, investing 50% of your cash hedges against the possibility that the additional drop in the stock market does not materialize. What about the other half? By leaving the other 50% of your cash as dry powder, you will be able to deploy those funds at bargain prices if the market drops further.
Investors that have the ability and willingness to increase the risk profile of their account should consider using these market corrections to increase their equity exposure. It's likely you will not time it perfectly, but there is a strong chance you will be happy with your decision if you look back five years from now.
Every client has a unique set of circumstances, so please don't hesitate to reach out if you have any questions. We are happy to have a conversation with you.
What Happened Last Month?
The S&P 500 just wrapped up its worst first half in decades. Investors had good reason to be concerned - economic data came in weaker than expected, inflation continued its surge, mortgage rates went to the moon, and consumer sentiment was abysmal.
Consumer sentiment: The final University of Michigan Index of Consumer Sentiment for June dropped to 50.0 from 58.4 in May. The June reading compares to 85.5 in the same period a year ago and is the lowest reading ever on records dating back to 1978. The key takeaway from the report is the understanding that the weakening in consumer sentiment was broad-based across income, age, education, geographic region, and political affiliation, due in large part to inflation concerns.
Inflation: On a year-over-year basis, total CPI was up 8.6%, versus 8.3% in April, and core CPI was up 6.0%, versus 6.2% in April. The key takeaway from the report isn't singular. There are multiple takeaways: (1) the price increases were broad-based, including price jumps for used cars and trucks and new vehicles, which many thought would be softening (2) the shelter index, which accounts for about one third of CPI, was up 0.6% month-over-month (3) the food index saw its largest 12-month increase (10.1%) since March 1981 (4) rising energy costs continue to challenge the peak inflation narrative and (5) the Fed is likely to stay on an aggressive rate-hike path.
Commodities have been the key driver of this inflation cycle, but prices have already come way down in energy, agriculture and metals. Wheat is down around 27% from its May peak. Corn is off by 14%. Natural gas has fallen by 30%. Copper is down about 20%. These declines may still take some time to be reflected in the end prices we'll see at the grocery stores and at the pump, but it certainly looks like the peak is in. Services inflation, however, is on the rise and could offset some of this. In my opinion, the headline inflation numbers over the next month or two could be really interesting. If we see a meaningful decline there, be prepared for a potentially big drop in bond yields that could return Treasuries to behaving like a risk-off asset and ushering in a strong rally in fixed income.
Mortgage rates: Mortgage rates were 5.9% (Wall Street Journal) on June 29th, 2022. For the week ending June 24th, 2022, fewer people applied for mortgages than at any point in the past 22 years (MarketWatch). Housing affordability fell 29% in March from last year, the sharpest decline on record. April existing homes were at their least affordable level since July 2007 (National Association of Realtors).
Mortgage rates near 6% have put a big chill on demand for homes. With home prices still at record highs, the affordability crisis has been dialed up to an 11 out of 10. Home sellers are aware of this as well; a record share are dropping their asking price. Even though there are fewer home sales, prices have not declined any significant amount yet. But if the housing market continues to cool, prices could fall in 2023." - Redfin (RDFN) Chief Economist Daryl Fairweather
Manufacturing data: Investors mull the increasing odds of a U.S. recession after weak PMI data. The June flash PMIs showed larger-than-anticipated declines in the headline measures with many key details deteriorating. In the manufacturing survey, the headline composite fell from 57.0 in May to 52.4, with a sharp weakening in the important measures tied to new orders and output. The services sector also showed signs of softness, with the headline composite declining from 53.4 in May to 51.6 and the measure of new business dropping 7.5 pts—the largest decline since the onset of the pandemic. With consumer sentiment at a record low level, these data show that the economy is now seeing the impact of higher commodity prices and higher interest rates on demand. However, there are few signs of weakening in the labor market so far with initial jobless claims edging down to 229,000 over the past week. Euro area flash composite PMI decreased by 2.9 pp to 51.9 in June, below consensus expectations. The weakening was broad-based across countries and sectors, with expectations of future
The U.S. markets are in the midst of a tug of war between two themes. The short-term features a short-term melt-up narrative based on overly negative investor sentiment and the notion that the worst news may already be priced in. The longer-term acknowledges a steadily slowing economy, an impending housing bust, the uncertain end to high inflation and a Fed that could make conditions potentially worse through its policy decisions.
As of now, the signals are mixed. The 10-year/2-year Treasury yield spread, which is a regularly watched recession indicator, is still in positive territory but barely. The alternate 10-year/3-month spread, which some consider a better predictor, is nowhere near negative territory and sits at around 1.4%. If we are on the brink of a recession, there's no reason to expect that it will be nearly as severe as the last two. Moreover, since the economy spends the majority of the time in expansion, for long-term investors, it is ultimately more important to be well-positioned for expansions than to try to tactically trade around recessions.
Noble Wealth Pro Tip of the Month
Benjamin Graham Lessons
The line between bold and reckless is thin. Investors often attribute their success to clairvoyance while dismissing to role good fortunes played. Some people are born into families that encourage education; others are against it. Some are born into flourishing economies encouraging entrepreneurship; others are born into war and destitution. That's not to say hard work and vision don't play a role in success; of course they do. It's just easy to ignore the luck and misfortune side of outcomes because it's messier and painful to accept. If you are someone who feels the cards are stacked against you, you may find solace in the lessons from the legendary investor, Benjamin Graham. Mr. Graham watched his family lose nearly everything and he was nearly ruined by the Great Depression. While unfortunate, he was resilient and he used these experiences to become one of the best investors of his time. These are a few of the simple lessons he learned:
Don't invest using borrowed money.
Never pay too much for the prospect of future profits.
Never count on greater fools to bail you out of reckless risks.
Above all, your results depend much less on how markets behave than how you behave.
Prudent Money Habits During Recessions
I'm not saying we are in a recession but there's a strong chance we see one in the next two years. It would be wise to begin preparing if we find ourselves in that unfortunate scenario. Review these three essential rules so you are better prepared.
Avoid panic-selling - individual investors tend to sell after an economic downturn is already priced into equity markets.
Pay down debts - use emergency savings to pay down debts. Paying off credit card debt is among the best things you can do when interest rates are rising and uncertain market conditions. Be careful not to use too much of your savings aggressively paying off debts with low interest rates, such as a 3% fixed-rate mortgage. You could find yourself short on cash during a downturn.
Review your spending - failure to reassess your budget and make frequent changes can leave you unprepared to adjust your spending during a downturn.
More on Series I Bonds
I wrote about I Bonds several times in this newsletter. If you are unfamiliar, they are bonds sold directly through the U.S. Government. The interest paid on these bonds is directly tied to the prevailing inflation rate. Money deposited into this bonds are currently credited with an interest rate of 9.62% for the next six months!
However, each calendar year these bonds have a limit of $10,000 (or $15,000 using money from a tax refund) per person. Some people are looking for ways to circumvent the $10,000 annual purchase limit. Remember, the limit is per social security number. This means you can deposit $10k in your own account, $10k in your spouse's account, $10k in a revocable living trust, $10k in an LLC, and $10k in your child's name.
Automation Can Keep Investors’ Emotions in Check
The average person tends to make poor financial decisions, and this behavior is exacerbated by complex scenarios. The average saver can become overwhelmed when it comes to their decision to save. Resulting in no action or no deliberate savings, which may impede their ability to achieve financial success. Furthermore, investors are terrible at timing the market on their own. They buy at the peak and often sell just as things turn around. Automating your financial decisions can help counteract these human instincts by delegating the judgment calls.
Consider a New Bank
As the Fed hikes, banks fighting for deposits are forced to raise savings rates to stay competitive. For significant amounts of invested cash, consider switching to a bank paying you to hold your savings. Click here to see a list of the banks with the highest savings rates.
What We're Reading
The Delusions of Crowds | William J. Bernstein
“We are the apes who tell stories,” writes William Bernstein. “And no matter how misleading the narrative, if it is compelling enough it will nearly always trump the facts.” As Bernstein shows in his eloquent and persuasive new book, The Delusions of Crowds, throughout human history compelling stories have catalyzed the spread of contagious narratives through susceptible groups—with enormous, often disastrous, consequences.
I listed some quotes from the book that I found interesting:
"The narrative arc of financial manias does not vary much either. Most speculative episodes combine two factors: exciting new technologies that foretell prosperity for all, and easy credit."
"Not only do people respond more to narratives than to facts and data, but preliminary studies demonstrate that the more compelling the story, the more it erodes our critical-thinking skills."
"Thus, the more a group interacts, the more it behaves like a real crowd, and the less accurate its assessments become."
“When one person suffers from a delusion, it is called insanity. When hundreds of people suffer from a delusion, it is called a cult. When millions of people suffer from a delusion, it is called a religion.”
Stop. Think. Invest. | Michael Bailey
The most successful investors, both professional and amateur, can benefit from this book. The author provides a balanced combination of intuitive story-telling and rigorous academic research makes worthwhile reading for both professional and serious non-professional investors. All investors will benefit from Mike Bailey’s coaching tips and revelations about behavioral missteps on their journey to investing success. Here are some interesting findings from the book:
Research has shown that only about 2% of the population can effectively multitask; the rest delude themselves into thinking they can.
Note the "halo effect" that occurs when your feelings about part of a company lead you to have an unrealistic, unrepresentative impression of the business as a whole.
Related to the halo effect is what Kahneman calls the "affect heuristic," which describes how people's preferences sway their actions and principles: You may avoid a business, product or company you dislike, even though its potential upside is far greater than its downside.
Don't rely too much on the impact a chief executive can have; only three out of five CEOs succeed. Kahneman, "Optimism is the engine of capitalism." But overconfident CEOs can be hazardous.
Feeling possessive about a trade and thinking of a stock as "mine" can make an investor unwilling to part with it. This is what behavioral economist Dan Ariely calls the "endowment effect," which can distract an investor from the factors that really matter.
Originals: How Non-Conformists Move The World | Adam Grant
For most people, being "different" than everyone else and standing out from the crowd is scary – an inclination that appears to be hard-wired into our brains as human beings, winnowed down by a natural selection process where those who conformed and stuck with the safety of the herd survived, and those who wandered off to do something different were eaten by predators. Being a non-conformist is risky business.
In "Originals", researcher and professor Adam Grant details the unique phenomenon that is the "non-conformist" and the somewhat counter-intuitive ways that creative non-conformists actually succeed. For instance, the conventional view is that creatives are successful because they have, well, more creative ideas than anyone else… but it turns out that the real determinant of success is not the ability to generate ideas, but the ability to make effective selections of which ideas to pursue with limited time and resources.
Our traditional view of non-conformist entrepreneurs as blind risk-taking leapers is not an accurate reflection of reality, and understanding how entrepreneurs who have a vision of how the world can be better navigate the risks and their own fears is the most empowering way to really take the leap to do something great.
Principles for Dealing with the Changing World Order | Ray Dalio
I had to add this book to one more newsletter due to its importance. As a society, we need to learn from past mistakes to avoid calamities from the past. In 2017, I was fascinated after reading a research piece Mr. Dalio wrote on populism (click here to read it). Mr. Dalio expands on his previous work to document the forces that lead to the rise and fall of great empires. Spoiler alert - America is demonstrating the archetypical attributes leading to an impending collapse.
Fun Facts of the Month
Private Colleges – The average cost is now $80,000 a year. Dark days are coming for most of the nations schools. Inflation will soon hit college income statements hard. Despite decades of tuition hikes, most Americans under-graduate institutions are in bad financial shape. 71% of colleges saw their grades decline – Forbes
Gun Violence – About 100 Americans die on average daily in the U.S. from gun violence – New York Times
Mass exodus - Approximately 300,000 teachers left their jobs between February 2020 and May 2022. A recent poll shows 55% of teachers plan to leave education sooner than originally planned, up from 37% last year – The Hustle
I hope he makes better decisions on the football field - In May of 2021, NFL player Trevor Lawrence decided to take his $24 million salary in Bitcoin. He has little to show after paying Fed and state taxes.
Price hikes - The consumer price index rose 8.6% in May, its fastest pace since 1982.
Russian default - Russia was poised to default on its foreign debt for the first time since 1918, pushed into delinquency not for lack of money but because of punishing Western sanctions over its invasion of Ukraine. The day marks the expiration of a 30-day grace period since the country was due to pay the equivalent of $100 million in dollars and euros to bondholders (6/26/2022).
No savings - Almost three in 10 people between 55 and 67 years old have less than $10,000 saved for retirement, every little bit helps - U.S. Senate Finance Committee
Yields - The yield on the 10-year Treasury note has more than doubled YTD, rising from 1.496% as of the close of trading on 12/31/2021 to 3.222% as of the close of trading on 6/17/2022. Over the last 60 years (1962-2021), the yield on the 10-year note has never doubled over the course of a calendar year - Treasury Department
Bear markets - After suffering 10 separate "bear" markets between 1950 and 2021, the S&P 500 recovered and eventually achieved a new all-time closing high each time. The average length of time it took to retrace its steps from a "bear" market low to a new closing high was 25 ½ months or more than 2 years. The quickest recovery for stocks took place over just 3 months (in 1982) while the longest recovery took 70 months or nearly 6 years (between 1974-1980) - BTN Research
Recession odds - 44% of economists surveyed by The Wall Street Journal have dramatically raised the probability of recession, now putting it at 44% in the next 12 months, a level usually seen only on the brink of or during actual recessions (June 21st 2022). More than 60% of CEOs expect a recession in their geographic region in the next 12 to 18 months, according to a survey of 750 CEOs and other C-suite executives. An additional 15% think the region of the world where their company operates is already in a recession (June 17, 2022) - Conference Board
Personal finances - One-third of young adults would rather deep-clean their bathrooms than check their savings account; and one-quarter say they would prefer to spend an hour with an ex-partner than draft a budget - Fidelity
Savings rate - The nation's personal savings rate, which soared during the early months of the pandemic, has now fallen back to below its pre-pandemic levels. The savings rate was 7.8% in January 2020, rose to 33.8% in April 2020, and now has dropped back to 4.4% in April 2022. The 4.4% rate is the lowest recorded in the United States since September 2008 - Bureau of Economic Analysis
Social Security funding - The estimated Social Security shortfall today (i.e., a present value number) between the future taxes anticipated to be collected and the future benefits expected to be paid out over the next 75 years is $20.4 trillion. The entire $20.4 trillion deficit could be eliminated by an immediate 3.24 percentage point increase in the combined Social Security payroll tax rate (from 12.40% to 15.64%) or an immediate 20.3% reduction in benefits that are paid out to current and future beneficiaries - Social Security Trustees 2022
Medicare funding - Per a 6/02/2022 report, the trust fund supporting Medicare Part A (hospital insurance) is projected to be depleted by 2028. The long-term (75-year) present value shortfall in the trust fund could be corrected by an immediate 0.70 percentage point increase in combined Medicare payroll taxes (from its current 2.90% to 3.60%) or an immediate 15% reduction in Medicare expenditures - Medicare Trustees 2022 Report
US Budget - The Congressional Budget Office projects that the spending of the U.S. government for the fiscal year 2023, i.e., the 12 months beginning 10/01/2022, will be $5.87 trillion, split between mandatory spending (62.6%), discretionary spending (29.9%) and interest expense (7.5%) - CBO
Foot off the pedal - The Federal Reserve began to unwind its "quantitative easing" (Q.E.) stimulus program last Wednesday 6/01/2022. Q.E. began early in the pandemic (March 2020) and provided money at a "near zero" interest rate to businesses and consumers for the last 2 years in an effort to stave off what could have been a severe national recession - Federal Reserve
Eurozone inflation - Inflation in the 19-nation Eurozone, i.e., the countries using the Euro as their common currency since 1999, was up 8.1% for the year ending 5/31/2022, a new high for Eurozone annual inflation - Eurostat
US Inflation - In April, the inflation rate measured by the Consumer Price Index (CPI) accelerated past its March high to a level not seen since early 1982 while the yr/yr core reading which strips out food and fuel receded to 6.0% from 6.2% in April and 6.5% in March.
SPAC returns - Through the end of May, excluding the value of included warrants or rights, the median return on shares of a SPAC combination or merger that went public this year was a loss of 43% - SPAC data and analysis provider SPACInsider.com
Insurance Rates - Car insurance rates are rising as much as 20% as insurers seek increases for which they believe will be more inflation. During the 1Q, All-State increased their rates 9.3% - Wall Street Journal