What I Care About This Week | 2022 Jan 24

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by Franklin J. Parker, CFA

The Summary

  • It appears the correction is here. It is a bit sooner than I expected, but it is, so far, well within the view that I have been expressing for some months. As I mentioned then, and I reiterate now, I do not see this as a recession. Rather, investors are pricing-away the influence of the Federal Reserve and positioning for interest rate hikes. I see a 15% to 20% total drawdown lasting four to six months. Given that forecast, we are likely about halfway down already. Of course, there are “tails” to this forecast: there are scenarios which could yield considerably more downside and lasting for much longer. Inflation is a major wildcard as it could easily trigger a recession if left unchecked.

  • Momentum is building for a confrontation with Russia over Ukraine. Rhetoric on both sides has grown more heated, and Biden specifically addressed the issue in his press conference last week, saying that the US would meet any Russian incursion with some proportional response. Sanctions are on the table, but many allies have pushed back as it would limit their ability to buy Russian natural gas and other resources. In any event, geopolitical instability is always a risk to markets, especially when a nuclear state is involved. As I have discussed before, there is a second-order effect: the CCP is surely watching the US response as a clue on what to expect regarding the US response to Taiwan. Taiwan is a much more important trading partner with the US, and could heavily influence markets—especially technology.

  • This week, all investor eyes will be on the Federal Reserve. Although no policy change is expected, Powell’s press conference will be watched for clues on the timing and extremity of rate hike expectations. Markets have priced-in more rate hikes than the Fed expects, so there is some possibility that an overreaction is in the works. Consumer sentiment data posts this week. After recent disappointing retail sales data, how consumers are coping with higher prices and omicron will be important.

The Details

Diversification means always being disappointed.

This is an important point to remember. In a portfolio that is well diversified, varying risk exposures means that something is always underperforming, It means that we could always have “done better” if we had simply allocated everything to the best performing asset. Of course, knowing which will be the best performer ahead of time is difficult, but more importantly, best performers tend to become worst performers with little to no warning.

The current correction is a perfect demonstration. While markets are selling off more-or-less in tandem, technology shares—previously the top performers—are selling off much harder than the market more broadly. In 2020, energy, for example, returned practically nothing while technology returned over 50%. 2021 saw a reversal of those fortunes, however, with technology returning about 20% and energy returning 37%, or almost double.

Diversification, however, gives us some very real benefits.

First, when we rebalance a diversified portfolio, we are automatically buying low and selling high. Taking our energy vs. tech example: rebalancing to a 50%/50% allocation at the end of 2020 would have us sell our tech positions that had grown to be 60% of the portfolio. By selling down tech and buying energy, we would have positioned ourselves to buy the outperformer in 2021. We sold tech at a high and bought energy at a low.

Second, a diversified portfolio helps insure that we are not making bets on positions or risk premiums that may underperform for long periods of time. There are long stretches where certain risks simply do not pay off. By capturing more of these risk premiums, we need not be as accurate in our forecasts and we have much more room for error.

Third, investing is often about surviving to another day. In moments of market stress, not holding only one type of risk significantly reduces the damage done. Diversification helps ensure our long-term viability.

While diversification means you’ll always be disappointed, it is also gives us our best chance of achieving long-term goals. Especially in the midst of market turbulence, diversification plus rebalancing is critical to our portfolio strategy.

Chart of the Week

One of the stories of 2021 was the large divergence between growth and value. Value ran ahead toward the beginning of the year, but then growth surged ahead toward the end of the year. Now, beginning in 2022, growth is again lagging. I expect that growth will continue to lag in the face of higher rates, while value may be in a position to pull ahead. This week’s chart demonstrates the difference in performance between growth and value—greater than 0% indicates the outperformance of growth, and less than 0% indicates the outperformance of value.

Historically value outperforms growth, over time and on average. However, a heavy focus on value tends to exclude the economic innovators. I do believe in allocating to value companies, but long-term investors are likely to do well also allocating to innovators, despite the increased volatility. The current dip may give investors an opportunity to allocate at better prices.

Performance of Growth vs. Value

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

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