Author: Franklin J. Parker

by Franklin J. Parker, CFA | for ongoing updates through the week, you can follow me on Twitter

The Summary

• The war in Ukraine has injected considerable uncertainty into markets. With Russia severed from the international economy, the prices of oil, natural gas, wheat, and corn have all surged. Russian oil is now reportedly around $20/barrel and still struggling to find buyers. Meanwhile, global oil prices have surged to about $120/barrel. Grains, especially wheat and corn, have also surged in price—Ukraine and Russia provide about 30% of the world’s wheat, so their “disappearance” from international markets has created a considerable supply shock. Both of these are likely to exacerbate an already concerning inflation problem.
  
  
• Speaking of inflation, this week we get February’s inflation data. Economists largely expect a figure around 7.9%—slightly higher than January. Of course, this data will not include the increased price of basic foodstuffs and energy seen over the past week. Whatever efforts the Fed will take at their March meeting, March’s inflation figure is likely to push still higher. In addition to inflation, we get data on consumer sentiment and job openings this week. All of these data points are important.
  
  
• I am watching economic signals very closely. At the moment, underlying economic growth appears strong, but that could begin to shift in coming months as the impacts of higher energy and food costs take their toll on consumers. The yield curve—a measure of the yields on offer for various maturities of US Treasuries—has begun to behave in a way that indicates economic growth is under threat. It may be a blip, but it also may be an early indication that growth is slowing. I have held 4000 – 4100 in the S&P 500 as my “buy” zone, and that is still the case. However, I am growing more cautious and this view may be revised in the coming weeks. Because of that, I would be more eager to buy after seeing some strength in markets rather than holding firmly to a specific number.

The Details

Stagflation is again a buzzword.

First, what is stagflation? We can think of the interplay between economic growth and inflation as occupying four basic quadrants, as the graphic shows. In a normal expansion, inflation is low and growth is high. Inevitably, a recession follows and that tends to see low inflation and negative economic growth. As an economy recovers, it can enter into an “inflationary boom” which is where demand outstrips supply and prices rise along with the general economy. One could make the argument that this is what we saw through 2021.

However, inflation has taken on a life of its own, and it has begun to put downward pressure on economic growth. Low growth and high inflation is called stagflation.

For many reasons, stagflation is a serious problem. For one, it hurts the poorest the most. As prices rise faster than wages, and economic growth suppresses hiring, lower-wage workers are saddled with ever-increasing costs and ever-decreasing economic opportunities.

Also of concern is the lack of tools the Fed carries to deal with this environment. To combat the stagflation of the late 1970s, the Fed took interest rates into the low 20%s. At that time, however, US government debt was about 40% of GDP. Today, government debt is around 134% of GDP. Taking interest rates just to 4% would put considerable pressure on the federal budget.

The cause of stagflation is also of concern: supply chain troubles and war are not problems easily solved by policymakers.

Exactly how all of this gets ironed out is most anyone’s guess. I expect it will be some combination of higher rates and “just hold on until it gets better.” For investors, this creates some headwinds, and, as I have repeated many times, adaptability and nimbleness will be key in this environment.

Chart of the Week

The past few months has seen a divergence between the economic outlook of business leaders and the outlook of consumers. The Business Roundtable’s CEO confidence index is hitting all-time highs while consumer confidence has been on a steady decline since mid-2021. Divergences like this are rare, and it may indicate the unique challenges facing US consumers and the opportunity seen by their business counterparts.

I follow CEO confidence more closely than consumer confidence since the latter is much more volatile. CEO confidence is also a pretty good indicator of slowing economic growth. I get more concerned when I see CEO confidence flagging. In short, this is a mixed economic signal, but I would err on the side of optimism rather than pessimism.

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.

by Franklin J. Parker, CFA | for ongoing updates, follow me on Twitter.

The Summary

• The dominant news of the week is Russia’s invasion of Ukraine. In response, Europe and the United States have taken a series of steps, one of which was unexpected and unprecedented:
  • Many of Russia’s major banks have been removed from the SWIFT international banking system.
  • Many of these banks have had their ability to transact with foreign banks severed.
  • Russian individuals have had their assets and property held in western allied countries frozen and/or seized, and their ability to move cash internationally severely curtailed (this includes Putin himself).
  • Western allied countries have also sanctioned the Russian central bank—an unprecedented action. This means that some, if not all, of the $630 billion held in foreign reserves by the central bank is now inaccessible to the Russian government. I detail more of this action below.
    
    
• To date, natural gas flows into Europe from Russia have not been curtailed (oil and gas payments have been excluded from the otherwise expansive sanctions). Despite all odds, Ukraine has so far prevented the Russian military from accomplishing any of its objectives—no major cities have fallen, Russia does not have air superiority, and the leadership of Ukraine is not only intact, but they have become an international inspiration. In response to this frustration, and the crippling economic fallout, Russian leadership has opened talks with the Ukrainian government, and increased the readiness of their nuclear arsenal. Clearly the second point is disconcerting. Despite these developments, US investors appear to be mostly shrugging off the uncertainty.
  
  
• In addition to developments from Eastern Europe, investors will be watching PMI and jobs data very closely. January jobs figures post on Friday. A key input to Federal Reserve actions, this will be a critical data point leading into the upcoming FOMC meeting. At the upcoming Fed meeting, officials are expected to announce the completion of quantitative easing and a rate hike. Both a 0.25% hike and a 0.50% hike are on the table (my view is that 0.25% is most likely).
  
  
• In my view, the Fed has not been entirely priced away from markets, that is still an ongoing process though it does appear to be coming to an end. The price-to-earnings ratio based on this year’s expected earnings for the S&P 500 is 18.5—down considerably from its 21.5 of just a couple months ago (a contraction in valuation of 14%). My view is that multiples have just a bit more to contract, but we are quickly approaching what I see as a buying zone. Remember, once valuations return to more normal levels, earnings growth (which is quite strong) will begin to push prices higher. Of course, inflation and a broader conflict in Europe are very real risks to this view.
  

The Details

Over the weekend western-allied monetary authorities took the unprecedented step of sanctioning the Russian central bank. It is easy to gloss over these words (“sanctions” don’t seem to mean much these days), but this is an action with serious teeth. Let’s break down why.

First, the Russian central bank holds some $630 billion in assets, mainly the currencies of other countries. In normal times, this would allow it to stabilize major currency moves. If the ruble began to show considerable weakness, for example, the central bank could sell dollars and buy the ruble and offer some support. By preventing the central bank from trading in international markets, this tool is removed.

Second, the central bank can tap these reserves to offer some liquidity in currencies other their own. Many Russian companies, to access international capital markets, have borrowed in euros, dollars, and yen. With no ability to get euros or dollars or yen, these companies could, at worst, default on their obligations and, at best, see their borrowing costs skyrocket. The same goes for the government of Russia—without an ability to get foreign currencies, they are unable to repay their foreign-currency debts (which is one reason why Standard & Poor’s downgraded Russian debt to junk status, further pushing up their borrowing cost).

Third, any actions the central bank takes to stabilize their financial system must now be done by printing money rather than from existing assets—which can compound the inflation problem.

Fourth, and this is related to the sanctions more broadly, the inability of Russian companies and banks to interact with the global financial system creates massive frictions for manufacturing and services. Since almost everything manufactured today contains components manufactured in a foreign country, and since payments cannot be made internationally, this significantly curtails the ability of Russian companies to produce anything other than the most basic goods.

Of course, many of these problems can be overcome. China offers a window to the international financial system, for example. But fund flows and supply chains cannot be simply rewritten overnight. In the short term, the effects of these actions are likely to create massive price inflation, depression of asset prices, and a significant slowdown of economic activity.

Chart of the Week

The economic damage done to the Russian economy can be seen in the movement of their currency, the ruble. It hit it’s lowest-ever value relative to the US dollar, moving some 30% in a day. Currencies rarely move like this. To put this in perspective, when the results of the Brexit election posted, the British pound moved 12% over the course of a couple of days, and that was major news at the time.

Unfortunately, this adds to inflation pressures in Russia, which is a very high cost the average Russian will have to pay.

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.

by Franklin J. Parker, CFA

The Summary

• All eyes are on the Russia-Ukraine standoff. Meanwhile, this week, the march of data continues. Consumer confidence and PMI data post tomorrow. Jobless claims post on Thursday with personal incomes on Friday. All of these data points are important, especially initial jobless claims, which have ticked up recently. So far, the economy has remained fairly robust in the face of inflation and ongoing covid concerns. With the landscape rapidly shifting, however, investors are closely watching for a potential slowdown.
  
  
• Earnings season is coming to a close with 90% of the S&P 500 companies having reported. It is generally good news, with 78% of companies reporting earnings above expectations. In summary, the S&P 500 is on track to post 31% earnings growth, year-over-year. Technology, despite all of the hubub, has posted the most beats, and utilities have posted the fewest. Inflation is a hot topic on earnings calls, and remains a wildcard in coming quarters.
  
  
• My portfolio view has not shifted. I still see a rocky first half to 2022, with the drawdown likely lasting another 3 to 5 months, and possibly reaching down 15% to 20% from the recent highs in the S&P 500. The Fed has been a bit confusing in their messaging lately. There is talk of raising rates by 0.50% in March, though that has not previously been on the table. For investors, the Fed meeting in March represents a significant event, and is likely to push prices around—as are the few meetings after. Once markets have digested the new backdrop, I see a return to growth in the back half of the year.

The Details

I (and many others) have talked extensively about the rise of so-called “zombie companies” in recent years. Though there is no standard definition, a Federal Reserve report defines a zombie company as (1) does not make enough money to cover the cost of their debts, and (2) has negative sales growth. In other words, zombie companies have to constantly consume new investor capital to stay alive.

One consequence of Fed policy over the past 15 years has been to make it considerably easier for zombie companies to survive. That Fed report also shows that about 9% of publicly-traded companies in the US is a zombie firm (I have seen other reports that put the figure closer to 20%). Since these firms tend to be highly leveraged and dependent on ongoing easy money, these firms stand to lose the most (all?) as leverage becomes more expensive and easy cash begins to dry up.

To date, investors have been content to back companies with a strong narrative—even if cash and sales have been in short supply. We can expect this willingness to diminish as the Fed abruptly changes course. Investors would do well to ensure that firms like this are not significant holdings in their portfolios.

Chart of the Week

This week’s chart is our final look at earnings for Q4 2021. With most companies having reported, the results are generally quite good. The S&P 500 has posted an average upside surprise of 5.5%, with technology representing the largest average beats. Energy has also done quite well, though. In sum, earnings season has been positive. Coming quarters, however, may be more challenging as rising input costs begin to eat away margins.

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.

by Franklin J. Parker, CFA

The Summary

• Lots of big news swirling around. First, tensions at the Russia-Ukraine border have intensified, with US officials warning today that military action may begin within the next few days. This has created significant jitters in markets, as a Russian invasion of Ukraine generates significant uncertainty around a US response. Though a military option is not on the table, the Biden administration has repeatedly said that targeted and painful sanctions are. As we have discussed here before, however, sanctions are painful to everyone, not just the target. Investors, at any rate, are in a wait-and-see mode.
  
  
• Inflation posted last week at the highest level in 40 years, a startling 7.5% (though economists were expecting a 7% rise). This has pushed investors to reevaluate the path of Fed rate hikes and monetary policy. St. Louis Federal Reserve president Bullard threw gasoline on that fire with his comments that he sees the Fed raising rates by half a percent in March, with a full percentage point increase by summer. This was a shock to markets as it represents a significantly more aggressive stance than previously expected. I see the Fed as unlikely to follow such a path, though recent inflation figures suggest that it is warranted.
  
  
• Earnings season continues to be fairly good, of the 72% of S&P 500 companies that have reported, over three-quarters of those have beaten expectations. Revenue growth has been quite good, but inflation is a hot topic on earnings calls. Inflation can be expected to erode profit margins over time: as companies begin losing pricing power in the marketplace, they are forced to eat their higher costs, which hurts profits over time. Investors will be watching closely in coming quarters to see how bad inflation is compressing margins—to date, companies have been able to increase prices to keep margins steady.
  
  
• My investment outlook has not shifted. It is still my view that we have a bit more downside to go, though I will readily admit that judging short-term swings is very very difficult. Inflation and the Fed are likely to keep volatility elevated over the coming six months. As I have said before, I do not yet see this as a recession and this downswing is likely to be short-lived, in my view. In the end, exactly how you position your portfolio is dependent on your goals, time horizon, and willingness to watch your statement value move.
  

The Details

I listened to a very interesting interview with Ryan Peterson, CEO of Flexport, last week on the All In podcast. There were several eye-opening points made about the current and future state of our supply chains, two of which were particularly concerning.

First, and most concerning: ports along the entire west coast of the US, Mexico, and Canada are operated by a single union, the International Longshore and Warehouse Union. As it turns out, their contract expires in July of 2022, and the last time their contract expired, there were severe disruptions to shipping. With ports already overloaded, disruptions this year could be catastrophic. The Wall Street Journal reported back in November that the union appears to be ready to dig in.

Second, the international maritime regulatory body (which sits under the United Nations umbrella) will require every fossil-fueled ship to reduce emissions by 13%, starting in January 2023. Of course, most ships cannot simply flip a switch to make that happen, and many of the technological innovations to reduce emissions have already been brought to bear. The only real way to immediately accomplish this objective is to reduce the speed of the ship, which, in turn, reduces emissions but also reduces the number of trips available within the same period of time.

Both of these points are enough to generate concern that our supply-chain woes have not yet peaked. Investors should keep a close eye on both developments and make provisions accordingly.

Chart of the Week

This week we look at an interesting graphic produced by Reuters detailing current Russian military positions, and possible paths of invasion into Ukraine. I must admit my amateurishness in this area, so I will refrain from commenting on possible motives and objectives of the Russian Federation. In the end, I am left to watch the events unfold along with everyone else, though some risk control here is warranted. War is an unpredictable thing, and with US/NATO troops all around Ukraine the risk of a wider conflict is not zero.

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.

by Franklin J. Parker, CFA

The Summary

• Payrolls for January posted last week. It was, on the surface, a good jobs report with 467,000 jobs added in January—considerably higher than most analysts expected. However, a change to how seasonal adjustments are applied did give a boost to the figure than we may have otherwise seen. Markets, in response to the strong figures, have begun to price five rate hikes from the Fed, which is more than the Fed itself sees for 2022.
  
  
• Interest rates have begun to bump up against some key levels. The 10-year treasury yield is now hovering around 1.9% and all of the expected cracks have begun to appear amongst high-flying tech names (and the new listings that are reliant on cheap capital). Inflation figures for January post on Thursday. 7.3% appears to be the expectation, which is still stubbornly high. With inflation in the crosshairs of the Fed, this print could easily push markets around.
  
  
• Rhetoric and actions surrounding the Russia-Ukraine standoff are adding to uncertainty. The US has sent troops to reinforce the area around Ukraine (though not in Ukraine itself), and talk of intense sanctions on Russia have grown. In last week’s report, I discussed the challenges of sanctions for investors so I won’t repeat them here. Suffice it to say, economic pain can be inflicted in both directions and investors should be prepared.
  
  
• Earnings season continue, and the news is generally good. Earnings growth has slowed a bit, and there is a big bifurcation: companies that are reporting profits seem to be reporting strong profits while poor reports seem to be very bad. Most notably, Meta, the parent company of Facebook, was severely punished after their lackluster earnings report—logging the largest 1-day loss in value of any company ever. This is, of course, adding to volatility in markets, as investors weigh earnings against the actions of the Fed. As I have said before, I expect this drawdown to be short-lived (though I do not yet believe we are at the bottom) and a good opportunity to deploy cash.
  

The Details

One of the first papers that was published on goals-based investing (though it wasn’t called that at the time) was on the effects of taxes in a portfolio.* The authors demonstrated that active trading strategies, even if they deliver better risk-adjusted returns, are often not good enough to overcome the tax drag they can create. In other words, it may look good on a statement, but not so good when the tax man cometh.

Seems strange to say now, but that one should account for taxes in an investment strategy was a new concept in 1993! In any event, it is just as relevant today as then, and our current market environment is a reminder of this.

I have, for months, talked about the likelihood of a selloff in the face of changing Federal Reserve priorities. Exactly how portfolios were prepared for this selloff, however, had as much to do with each client’s tax situation and financial goals as it did my view of the selloff itself. For short-lived selloffs, it is often not profitable to sell highly-appreciated positions to reset at slightly lower prices. The taxes on those sales often erodes the benefits of active management, no matter how accurate that active management may be.

There are moments, of course, when it is worth the tax cost.

The point is simply this: taxes are a critical factor in your investment strategy. They must be accounted for. Taxes are also highly individualized, so it can easy to disregard these variables in a general strategy. That is, in my view, a mistake. Keep an eye on tax costs.

*Jeffrey, R., and R.D. Arnott (1993) “Is Your Alpha Big Enough to Cover Its Taxes?” Journal of Portfolio Management, DOI: https://doi.org/10.3905/jpm.1993.710867.

Chart of the Week

This week we check-in on corporate earnings. As a whole, the S&P 500 has had 77% of reported companies beat expectations, with an average surprise of 4%. Of the companies that have reported, tech has had the most companies beat expectations (communications have only had 5 earnings reports, so I discount their 100% above expectations figure).

In sum, this is turning out to be a pretty good earnings quarter for US companies. Outlooks have shifted, however, with some sectors seeing considerably more downward revisions than upward (materials, for example). Even still, as a whole, the S&P 500 is seeing more upward revisions in expected earnings than downward.

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.

by Franklin J. Parker, CFA

The Summary

• The Fed delivered a mixed message last week. On the one hand, guidance hasn’t changed: money-printing is set to end in March, and rates are to stay low until the money-printing is done. On the other hand, there is a growing consensus that March will see at least a 0.25% rate hike, and possibly even a 0.50% rate hike. Powell also acknowledged the challenge with managing the Fed’s balance sheet, and though he did not explicitly say this, I got the sense that the Fed would wait until about mid-summer to begin shrinking their balance sheet. All of this means that the Fed will be a dominant and downward force on market prices until probably August/September of this year, and that will be in a tug-of-war with economic fundamentals, which are improving as evidenced by last week’s GDP print for Q4, which posted at a blockbuster 6.9% (5.5% was expected).
  
  
• Personal consumption expenditures decreased slightly for December, posting in-line with expectations. PCE is the Fed’s preferred inflation gauge. With a modest decrease—the lowest print since Feb 2021—markets took this as a glimmer of hope that inflation may be peaking. I remain unconvinced, as this is likely just driven by slowing consumer demand rather than slowing price increases. Recall, my wildcard risk for 2022 is inflation as it can push an economy into a recession by stunting capital expenditures and consumer spending.
  
  
• This week we get some insight on the health of manufacturing and services with PMI data. A reading of the labor market, we get JOLTS job openings data and the usual weekly print of initial jobless claims (though that figure has become less important in recent months), and the headline unemployment rate for Jan. All of these are important data points. I am watching closely for clues on the health of the overall economy, and all of these figures are key on that front.

The Details

The Wall Street Journal reported today that Ukraine-Russia tensions have pushed up wheat prices (though it does appear the upward trend began years ago). I have been talking about my concern for increased tensions for the past few months. But, how concerned should investors be from the perspective of their portfolios?

First and most important: markets do not like uncertainty. War (or a regional conflict) is among the most uncertain things that markets can experience. In general, then, the potential for hostile actions simply adds to volatility and will tend to depress prices.

That said, it appears unlikely that the US and her allies would risk an open war with a nuclear-armed Russia. It has been the policy of the United States to avoid open wars with nuclear states at all costs. Though I must admit my non-expertise in this area, I see a US war with Russia as a very low-probability scenario.

Even if the US and her allies are not involved, hostilities still disrupt the lives of millions of people, cut off trade routes, and disrupt production in the areas around the conflict. This is obviously bad for economic activity.

Furthermore, the US and her allies have indicated they would impose crippling sanctions on Russian oligarchs as well as Russia herself. While US trade with Russia is relatively insignificant (Russia is the US’s 26th largest trading partner with about $35 billion in goods traded per year), Russian trade with the European Union is much more significant. Russia is the EU’s 5th largest trading partner (and the EU is Russia’s largest trading partner). More importantly, Russia supplies over a third of the natural gas used by the EU.

In other words, sanctions, though painful to Russia, are also painful to Europe. Europe is already struggling with economic growth and inflation, and sanctions are sure to exacerbate those problems. This regional conflict, then, could be the straw that breaks the camel’s back, pushing Europe into a recession.

Chart of the Week

Market volatility is back! Although, much of what we have seen is normal, we just forgot because the Federal Reserve has been pulling volatility from markets for the past decade. The recent bounce in markets has led some to question whether the selloff is over. While it is very, very hard to predict these things, my view is that we have a bit more downside to go.

In the chart below, I have plotted my baseline case for the S&P 500. I expect March/April to be the bottom, and I expect the S&P 500 to be down 15% to 20% at the bottom. It is not uncommon to see a bounce after hitting an important milestone (down 10%), but there is still significant overhead resistance for markets around the 4500 level. Unless markets push above that level with some conviction, I do not believe the recent bounce has escape velocity.

Again, short-term swings are notoriously hard to predict, so I may well update my view as new data and market action comes in.

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.

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.

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.

by Franklin J. Parker, CFA

The Summary

• Inflation is the hot topic, with producer prices and headline inflation both posting very strong readings last week. This increases the likelihood of the Fed raising rates at their March meeting. Also—and this was a big disappointment—retail sales posted considerably weaker than expected for December calling into question the strength of earnings season. Weak retail sales may also indicate that consumers are beginning to feel inflation’s pinch—a bad omen if they continue.
  
  
• Russian rhetoric over Ukraine has grown more intense, claiming that talks have “hit a dead end” all while Poland warns European leaders that the risk of war has gown. While not a direct market concern, threats to geopolitical stability significantly increase the uncertainty that currently hangs over market prices. Russia’s leverage over Europe is, of course, its supply of natural gas. Prices have varied wildly since tensions began, but the strength of that leverage should wane once winter passes.
  
  
• From a portfolio perspective, I have grown increasingly pessimistic. Markets have less and less to look forward to, and the Fed’s commentary has grown much more hawkish over recent weeks (especially in light of recent inflation and employment figures). I maintain that this does not look to be the end of the cycle, but I do think the risk of a significant correction in the next month or two has grown. As I have always said, however, how you position your portfolio will be dictated by your goals.

The Details

Much of the upward momentum we enjoyed coming out of 2020 has been spent, and markets are now fighting for every upward step. Of course, the main portfolio challenge is that bonds and stocks are struggling together, so the benefits of diversification are significantly lessened.

There are diversifiers, however. In an inflationary environment, energy tends to outperform as do most commodities (especially food-based commodities, like corn, wheat, etc). Bank stocks should benefit from a steeper yield curve, and gold marches to the beat of its own drum, which can be good in a portfolio. I am cautious, however, of other asset classes that have been labeled “alternative.” Real estate, for example, is likely to be negatively influenced by higher rates (just like stocks and bonds), and venture capital/private equity have the same challenges. That is not to say we should not own them, just that the role they play in a portfolio should not be as a diversifier.

I see 2022 as a difficult year for investors. While the back half of the year will probably be better than the first part of the year, I’m not confident we will see the double-digit returns that we have seen for the past few years. For existing clients, I have already been making portfolio adjustments (and will continue to do so). For folks who would like a second opinion on how they are positioned for 2022, we would love to chat with you.

Chart of the Week

Covid has wrought havoc on supply chains, and some price increases are certainly due to that. However, it is very hard to ignore how much the supply of money has increased over the past year. Through 2020, of course, the money supply expanded by 25% year-over-year, which is the largest expansion, by far. However, even if we were to take away that spike, the current money supply expansion would be the largest since 2008 (which was the previous record).

You can think of a dollar as a share of the economy. When the economy is growing each dollar is worth more. When we create more dollars, we subdivide the economy into more pieces, making each dollar worth less. So, there is a tug-of-war: more dollars make each dollar worth a bit less, but a growing economy makes each dollar worth a bit more. Inflation happens when we create dollars faster than the economy grows.

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.