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The number #1 red flag when looking at a financial scam is “You must act now!” This statement creates a sense of urgency for the buyer which entices you to act. Frauds and scams are on the rise of late. I have had clients call in 3 consecutive weeks now about potential scams. The criminals seem to be upping their game. The first fraud was thousands. The last one was hundreds of thousands. Is this a sign of a weakening economy? It could be. If you find yourself in a situation where you are in doubt, you need to trust your instincts. These scammers are out there, and they are smart and have honed these scams down to a science manipulating you based on psychological principles. Keep an eye out for red flags.
Good investing is overwhelmingly just about how you behave. It’s about your relationship with greed and fear, how gullible you are, who you trust, who you seek your information from, your ability to take a long term mindset, long-term time horizon.
– Morgan Housel
The latest “product” – I call it a product but it is really just another Wall Street scam – to come across my desk is Buffered ETFs. Buffered ETFs are another play on your psyche. It’s not a coincidence that I am seeing a daily email barrage for Buffered ETFs in a down market. In a down market, fear rises. Buffered ETFs play on that fear and the promise that these Wall Street firms can protect you and limit your downside.
Here is how Wall Street profits from fear and the Buffered ETF play. The Wall Street firms see the market currently down 20%, with maybe another 10-15% downside. Fear is rising, but they know the downside to the market is limited. The upside, on the other hand, for markets is fundamentally unlimited. So, the Wall Street firms tell you that they can limit your downside to 10% – where they see the logical lows – while Wall Street collects any upside over 10%. This is all while collecting fees from you all along the way. Heads Wall Street wins, tails you lose. Years ago, in a down market, I had a fear-filled client present a similar strategy to me to protect him from losses. I advised against it, as the strategy forced him to sell if the market went down 10%. Never be forced to do something! He didn’t take my advice. He lost $1 million within six weeks.
Beware of Greeks bearing gifts.
– Virgil 20 BC
Beware of geeks bearing formulas.
– Warren Buffett
How to Manage Your Fear
Basic Underlying Thought #1
You must take a long-term approach and mindset when investing. There is much concern from both sides of the aisle about the leadership in Washington. Let me tell you this, we have survived and thrived as a country not because of our leadership but despite them. We will do it again.
Example: The Russian sanctions over Ukraine. It is pure idiocy. We are effectively sanctioning ourselves. The IEA reported last month that Russia’s oil revenues are up 50% this year. The sanctions have pushed oil prices to their highest level in a decade. The US and Europe were not ready for war with Russia, but Putin was ready. Europe is paying a heavy price for their lack of preparation. Politics aside, the important thing to do is analyze who we think the winners will be in this environment of inflation, higher food and oil prices and geopolitical upheaval.
How do we profit? We may see a move away from US-centered investments – away from the growth stocks that have done so well for us. We see a move towards real assets that may last for a decade or more. We will need to invest in the polar opposite way that we have for the previous 30 years.
Basic Underlying Thought #2
The stock market is rigged. It is rigged in your favor. On an annual basis, the stock market goes up 78% of the time. So many people benefit when the stock market goes up. Pension funds, insurance companies, individuals and the government all benefit from higher asset prices. Could it be that the Federal Reserve would like asset prices to go down for a time? Perhaps, cool off the speculative excess? That is their job. That’s what they are doing. Betting on the end of the world is a bad bet.
Why stay in the market? There in old saying in football. When you pass the ball, there are three things that can happen and only one of them is good. In investing, when you are long assets, there are three things that can happen but two of them are good. If we are long and asset prices go up, we make money. If asset prices go nowhere, we make money through interest and dividends. The last scenario is if markets go down, we expect to lose money.
The Oil Decade
Inflation is a battle that may go on for a decade or more. The Federal Reserve can only raise rates so high before the economy sputters out. They will not have the political will to strangle the economy. We are also amid a sea change from globalization to one more in line with regional cooperation. That takes time to reset supply chains and costs money. Wages are also headed higher over the next decade as more and more corporations onshore their supply chains. Gone are the days of cheap Chinese labor.
Oil will benefit as oil companies refuse to drill to create more supply. This is in response to environmentally concerned politicians in Washington refusing to acquiesce to less-stringent regulations of fossil fuels. Energy companies have learned their lesson over the past decades. In prior regimes, they would be pumping oil as fast as they could to take advantage of high prices. That would lead to rising capex costs just in time to see prices fall. The old saying was “the cure for high oil prices is high oil prices”. We think that no longer holds true. Oil majors are not making the same mistake this time. We may be at the very beginning of a commodity super cycle. As evidence of that, the CEO of Chevron (CVX) last month told the CNBC audience that he felt that a new refinery will never be built again in this country. This change in corporate strategy will not help contain inflation, and we need to invest our portfolios accordingly.
Inflation Concerns Morph Into Recession Concerns
The Federal Reserve has been responding to the need to cool off inflation. To get inflation under control, we need to get the price of oil lower. They basically only have one tool. That is to tighten policy, so the economy cools and possible spirals into a recession. That is the risk that they must take to try and tame inflation. Not very efficient, but getting the stock market down also helps them accomplish their goals.
It’s important to understand that the market consensus view has now changed from inflationary concerns to concerns about a recession. While inflation has been the obsession of the market, investors are now accepting that there is a Fed-induced recession on the horizon and are beginning to consider that when calculating asset valuations. Copper and the yield curve are two of the clearest indicators of a looming recession. The last few weeks have seen copper take a big hit. The yield curve is now inverted for the third time in recent months. These are clear signs that a recession is on the horizon. This comes 6 months after we let you know. The Fed is raising rates into a slowdown, effectively creating a recession. It is their only weapon to fight inflation. Everyone is now aware of the looming recession. It may be time to pivot again.
The Plumbing – The Real Cause For Concern
We are always focused on the plumbing of financial markets. That is where the real risk in markets resides. If you have read our note for some time, you have heard us rant that the day-to-day narrative in markets does not really matter. What matters is when markets develop liquidity issues, or what we call plumbing problems.
The Fed recently raised interest rates by 75 basis points (bps). The last time that the Fed raised rates 75 bps in one meeting was in 1994. That led to what is known as the Tequila Crisis. They broke Mexico and the Fed had to step in a save the day. By raising rates aggressively, other currencies begin to suffer. We may see a recession akin to 1994, which was a mid-cycle correction. The market then soared until 1999. There have been rumors of late that the Japanese have asked the Americans for help in dealing with their falling currency. The word is that the Americans said “no”. We were in the market in 1998 when the Asian currency crisis rocked the investing world. Currencies are big and move with great force. Imagine a wave of water. Most times it’s a normal small wave and we think nothing of it. What happens when a rogue wave hits? Water can be one of the most destructive forces on earth – so can currencies. The spiraling currency of the third-biggest economy on the planet bears watching.
For political cover, the Fed will hike until something breaks. They can then clearly stop and reverse course. When the plumbing in the system breaks, central bankers begin to panic. It is when central bankers begin to panic that markets stop panicking. My current guess for what is going to break is a currency in Asia. It is quite possible that it will be Japan. If central bankers take it that far, it will be an obvious buying opportunity as markets sell off.
What’s Next
Investing is a game that is incredibly complicated and can never be truly mastered or perfected because it never ends. We have seen this range-bound market coming for six months, and even before that, we saw inflation on the rise in the post-pandemic period. So, what’s next? That’s always the question. We are still seeing the impact of the pandemic and the shutdowns. Everyone wanted TVs and furniture. Companies like Target and Walmart ordered tons to be delivered. Everyone has moved on. People want clothes and travel now. What’s next? A hangover probably – a debt hangover. For now, the consumer is saying in polls that the economy stinks, but I think they mean inflation stinks.
One thing that we are resolute on is that the blue-collar worker now has the advantage. For 40 years, the pay of a blue-collar worker has been shrinking while the white-collar worker and the asset owner (think stocks and real estate) have been the big winners. The demographics in the post-pandemic period are still in flux and need to rebalance. That gives the advantage to the blue-collar worker. Politicians and central bankers seem to be on the side of Main Street, as the Federal Reserve has chosen to combat inflation by bringing down asset prices. This is the beginning of a long and difficult investing decade.
The copper/gold ratio tells us that the 10-year Treasury should be yielding about 2%. Currently, it is yielding 2.8%. We may have seen the near-term bond yield peak as recession risks rise. Earnings are the next concern for investors as the economy slows. While the prices of stocks have come down, earnings estimates are still elevated. That may be the next shoe to drop. A lower 10-year yield could provide some cushion to stock prices. While we may see a contrarian rally in junk bonds and tech stocks, those rallies may be short-lived. We are in the midst of a bear market. Bear market rallies are sharp and violent moves to the upside. Don’t get fooled. A rally in the market only emboldens the Federal Reserve and gives them cover to further raise rates, while only bringing the recession swifter and deeper. We think that cash, volatility and commodities will continue to outperform stocks and bonds in 2022 until investors capitulate and send the S&P 500 to the lower 3000s from its current 3800.
We have noted for months that we are stuck in a bear market. A bear market with a range of 3800-4800 for another 10-14 months. That does not mean that the low is 3800 or that it will be hit 14 months from now. We will see some dips and rips as the market is stuck in negative gamma. Negative gamma works both ways, and that is why you see some of the biggest up moves in markets during bear markets. An average recessionary bear market sees a move lower of 34%, so we are 60% of the way to a typical recessionary bear market. Why not sell it all? We are not guaranteed to see the big selloff. Systematic traders and hedge funds are underinvested and prepared for a selloff. One word from the Fed and we could be off to the races. We should continue to stay invested, but with dry powder while we adjust risk in the tail end of the range and collect our dividends and interest. We were, and are, prepared for some rougher seas.
In the coming months and years, we may see a very different environment. An investing environment in which very few of us have any experience investing. After four decades, we see the end of the era of Wall Street inflation and the beginning of Main Street inflation. This is the end of globalization and the beginning of isolation. We see profits made being long value stocks, real assets and commodities, while shying away from Big Tech and growth stocks. The Fed is trapped. While they wish to support Wall Street assets, they are leaning towards holding down Main Street’s inflation.
We have a strong hand, and are positioned to benefit from buying at the lower end of the range and selling at the higher end. It is the poorly prepared or weak hands that cannot buy at the lows and add to positions or worse, yet sell at the lows because they are forced to. We don’t have to, and can wait it out because we are appropriately positioned.
The end of this bear market will come when we see more layoffs and it becomes politically untenable for the Federal Reserve to keep raising rates. The stock market is already discounting a mild recession. We have suspected since the dawn of 2022 that the Fed tightening cycle would be shorter than consensus. They are walking a fine line, and politically will not be able to really keep the hammer down on inflation as unemployment ticks up and the stock market ticks lower.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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