Sitting here at home on Memorial Day under quarantine, gives one the time to think. We should all be grateful to the men and women of the Armed Services for all they have sacrificed to enable us to live the life we wish. May we never forget that freedom is not free! There are a lot of other countries that are not so fortunate.
The big elephant in the room is the long awaited stock market correction everyone was trying to outthink. Whether it was the almost 20% drop in the S&P 500 from the Jan 3, 2022 highs, to the continuous issued US 10 Year Treasury bond hitting 3%, a little panic ensued.
This is what I am seeing and thinking: the commentary of “are we in a bear market” is the same as crying wolf over time. The definition of a bear market, is down 20%, who gave it that level? If we are down 19.8% are we in a bear market, or if we are down 20.1% are we in a bear market? Is there much of a difference, I think not.
If we are truly investing for the long term, then we must welcome these corrections as they take excesses out of the market.
If we look at the chart above we see that earnings drive the market over time, and the current correction has brought the market back to 2014 levels with regards to the current Price Earnings(PE) multiple of around 17.4. The excesses we had from the monetary and fiscal stimulus resulting from Covid, will be replaced by earnings going forward. In other words the peak PE of 27.2 was a result of the entire stimulus that was VERY slow to be withdrawn, both fiscally (Government) and monetarily (US Federal Reserve).
From Factset May 26, 2022 we have the following with regard to the Q1 S&P 500 earnings that were just recently reported:
Inflation was mentioned 398 times (more on that later)
Energy earnings were up 298%
68 companies provided negative guidance for Q1/2022
S&P 500 earnings were up 9%, this was the lowest since Q4/2020, keep in mind, still up.
77% of the S&P 500 companies exceeded Earnings Per Share (EPS) estimates
In the simplest case, inflation is due to two things, demand and supply. Both need different approaches to slow it down. With regards to demand, we had Covid which caused the economy to be shut down. The US Government then stepped in and artificially created demand through stimulus checks, payroll protection, lack of foreclosure and other programs, essentially saving the economy. People and corporations kept spending, companies kept earnings going and the market looked past Covid to see upward earnings in the future and the stock market went up. Probably up too much. In my opinion the Government was too slow to shut off the fiscal stimulus. I can understand their reluctance as in the past they have shut stimulus too soon and the economy relapsed into a recession. The solution for inflation is to raise interest rates hopefully slowing demand.
With regards to supply we have different issues to deal with. Quite simply at this time we are in a supply issue forcing prices to go up over which the Fed has no control, and raising the interest rates to slow inflation is the wrong approach. Take your pick among Covid, Ukraine, China lockdown and our lack of inputs for our economy, bad domestic energy policy and you have the recipe for supply inflation.
We have control of our own energy prices if we wish to, and if you look at the chart above, energy prices are a major driver of inflation expectations going forward. I would prefer we make the decisions regarding our future energy prices rather than the governments of the Middle East and Russia, whose interests do not necessarily align with ours. We will stay overweight energy in the portfolios. China is left out of this as they are generally short 4mm barrels of oil a day, and need to import almost all of their oil from the Middle East (mainly by tanker).
The following is from the Equity Chart Book of Merk Research written by Nick Reece, CFA. I have included this as I feel very strongly that this Bias Towards Action causes long term investors to make short term trading decisions. Long term investment portfolio construction is different from short term portfolio construction and different skill sets.
“Behavioral economics suggests that people have an inherent bias towards action—doing something often feels better than doing nothing, and provides the illusion of control. But in reality, doing nothing is often better than doing something. And long-term investors should avoid trying to become short-term traders. As always, everyone needs to put probability and reward-to-risk assessments in the context of their strategy, process, and time horizon.” -Nick Reece, CFA
The Bias Towards Action
“Investors today appear to have chronic attention deficit hyperactivity disorder (ADHD) when it comes to their portfolio... As Keynes observed, “Human nature desires quick results, there is a peculiar zest in making money quickly” ...Not only do we desire quick results but we love to be seen as doing something (as opposed to doing nothing); we have a distinct bias towards action.
Soccer goalkeepers provide us with a great example of this unfortunate tendency... Although not normally the stars of the team, it transpires that when it comes to penalty kicks top goalkeepers are action men. A recent study revealed some fascinating patterns when it comes to trying to save penalties. In soccer, when a penalty is awarded, the ball is placed 11 meters from the goal, and it is a simple contest between the goalkeeper and the kicker. The goalkeeper may not move from his line until the kick has occurred. Given that in the average soccer match 2.5 goals are scored, a penalty (which has an 80 percent chance of resulting in a goal) can dramatically influence the result of the game. So, unlike in many psychological experiments, the stakes are significant. Our intrepid researchers examined some 311 penalty kicks from top leagues and championships worldwide. A panel of three independent judges was used to analyze the direction of the kick and the direction of movement by the goalkeeper... Very roughly speaking, the kicks were equally distributed with about one third of the kicks aimed at the left, center, and right of the goal mouth. However, the keepers displayed a distinct action bias: They either dived left or right (94 percent of the time), hardly ever choosing to remain in the center of their goal... Yet, they would have been much more successful if they had just stood in the center of the goal. According to the stats, when the goalkeeper stays in the center of the goal he saves some 60 percent of the kicks aimed at the center, far higher than his saving rate when he dives either left or right. However, goalkeepers stay in the center only 6 percent of the time. The goalkeepers were asked why they choose to dive rather than stand in the center. The defense offered was that at least they feel they are making an effort when they dive left or right, whereas standing in the center and watching a goal scored to the left or the right of you would feel much worse...
The antithesis of this action bias is, of course, patience. Patience is a weapon you can use to protect yourself from becoming an ADHD investor.”
- James Montier
If there are ever any topics you wish for us to explore, please let us know. We are here to help and guide you through these times.
We thank you all for taking the time and reading “Market Watch.” It is meant as an educational piece on the always evolving markets. It is something we plan on providing every month, and your feedback is very important to us.
On a personal note, RMH is now in the position to bring on new clients so please be sure to share this informational letter with whomever you wish. RMH’s focus is on the customizable investment needs of individuals, families, and foundations. We enjoy working with our clients to better understand their goals, values, and passions for what is important in their lives. In expanding our client base, we look forward to working with people who share these same desires.
Richard Mundinger, CFA
John Butters May 26, 2022: Earnings Insight: Q1 “22 By the Numbers
Merk Business Cycle Report, May 5, 2022
Merk Equity Market Report, May 27, 2022: The Bias Towards Action