A confluence of factors continues to catalyze choppy, rangebound markets as investors strive to determine whether the Fed will be able to bring inflation under control prior to the U.S. economy falling into a recession. The convergence of the two lines inside the yellow oval on the far right of the 60+ year graph below speaks to this dilemma facing fundamental investors. On the one hand, the Fed’s main inflation metric surprised last month (white line, right axis) to the upside, while last week’s ISM Manufacturing Index (red line, left axis) screamed recession.
The first two trading days of February for the S&P 500 exhibited the same fear of missing out (FOMO) activity that played a significant role in fuelling the big move higher in stocks during January. Thereafter, slowing inflation (bullish), but not at a fast enough pace (bearish), provided fodder for both the bulls and the bears, keeping equities range-bound until mid-month when a stream of divergent data caused equities to ultimately succumb, giving back roughly half of their January gains.
January kicked off 2023 with equity markets continuing to exhibit the same ‘chop’ that characterized 2022. However, unlike many months last year, likely only dedicated short sellers or investors sitting mostly in cash complained at last month’s action. The price of stocks and bonds surged for three reasons.
For the second consecutive year, predicting the rate of inflation should prove to be the most important variable for investors to consider as we enter 2023. During the holiday season of 2021, the Fed’s median projection for the upper bound of the Fed Funds Rate for year-end 2022 was 1%, with the terminal rate forecast to ultimately reach 2.5%. Investors were happy with those estimates and stocks exited 2021 trading comfortably north of 20X forward earnings. The world then changed, causing most investors to suffer sizeable losses during 2022. In this note, we will review last year, discuss the performance of our funds and table our outlook for financial markets during 2023.
This year’s U.S. Thanksgiving was no turkey for investors as the price of pretty much everything, other than energy commodities, moved sharply higher. There were three drivers catalyzing this fifth beta rally during an otherwise tough year for investors: October’s softer-than-expected U.S. inflation data, soothing words from Fed officials, and the positioning of investors. The key question is whether this latest rally is another headfake, or does it constitute a sustainable bounce off the bottom. Before tackling this question, let’s review the performance of our funds.
Based on the aspiration that the timing of the Fed’s inevitable pivot may occur before year-end, perhaps as early as last week, equities enjoyed a huge move higher during the month of October. Unconvinced that various macro variables had yet to advance from flashing yellow to exhibiting the all-green, our funds remained conservatively positioned. While frustrating to the team in light of the big bounce in equities, given our long-term net returns, we’re cognizant that protecting client capital during this exceedingly rough 2022 has been top-of-mind for our investors. Hence, we will continue to aim to be the tortoise versus the hare. After discussing last month’s results, this note will update our views on the outlook for markets and the positioning of our funds.
In light of the growing stagflationary environment, investors experienced the full brunt of the renewed downside correlation between stocks and bonds during September, historically the worst month of the year. For the first time since 1938, the S&P 500 closed the quarter with a negative return (-5.28%) after earlier rising more than 10% (+14% July through mid-August gain) as breadth turned strongly negative during the last month of the quarter. In fact, to highlight what has become a year-to-date trend, 56.4% of all trading days during 2022 have shown declines for the SPX, including 26.1% of those days featuring declines of at least 1%. Perhaps even more startling, the Nasdaq-100 and long-term US Treasuries are both down by roughly 30% since the start of January and yields on U.S. 10-year bonds hit 4% for the first time since 2010.
Several months ago, investors began to think about stagflation, yet only during the past few weeks have they started to discount the potential for such a nasty outcome into the price of stocks and bonds. Equity indices, including the S&P 500, which had exhibited sharp gains at the start of August, fell hard towards the end of the month. After failing to surpass its 200-day moving average to the upside, the 50-day moving average provided no downside support, as the S&P 500 quickly descended towards 3,900. Once again, the catalyst for this volatility was the latest flip-flop by Fed Chair Powell, as his recent remarks made it quite clear there was no ‘Fed put’ on the horizon.
Sometimes, an investor is simply out of step with markets and that’s the way it has been of late for the team at Forge First. Aside from our ongoing constructive stance on Energy, given our concerns about stagflation, each of our two funds has maintained their exceedingly cautious net exposures. Obviously, given the strong countertrend rally in equity markets, this positioning hurt the funds during July. After reviewing the numbers, this note will discuss why we remain cautious towards stocks, including a fact check on the outlook for inflation.
While we all knew the party was going to end at some point, few expected such a reckoning to begin during the first half of 2022. In our year-ahead commentary, published in early January, we cautioned investors that 2022 could be a down year for markets based on the impact of sticky supply chains and weakening economic growth. However, we saw market weakness in H2, not H1. The principal reason for the earlier-than-expected shellacking of all things financial was clearly the Fed. The central bank of the U.S. waited far too long to admit inflation wasn’t ‘transitory’ and then shocked the market with a 180-degree turn during the 2nd week of January. Yet, talk is cheap (except for the negative wealth effect on investors) because, as you can see from the white line on the 15-year graph below, as of June 30th, the Fed has yet to begin to shrink the size of its balance sheet. But let’s not get ahead of ourselves, and prior to reviewing the second half outlook for markets, let’s recap H1 and discuss why June was so ugly.
One of the well-known quips about investing is that there are fewer things more humbling than markets. In last month’s commentary, we mused that by Labour Day markets would sense a pending shift by the Fed, be it dovish or hawkish. Then, lo and behold, near the end of April, in light of weakening Chinese data and plummeting U.S. housing data, market psychology assertively pivoted towards growth fears from concerns about inflation. The impact of this shift dominated market action during May, especially after Target Corp. (TGT.US) and Walmart Inc. (WMT.US) tabled sizable overhangs in their inventory positions and the latter joined Amazon.com Inc. (AMZN.US) in announcing a hiring freeze; two companies that employ three million people. As a result, markets exited May amidst a “perfect storm” of P/E multiple compression, profit margins that are rolling over and the rising prospect that revenue growth will roll over thanks to supply issues and the growing prospect of an economic slowdown.
Long-only investors endured a rough April as stocks unwound 100% of their H2 March rip higher, while bonds remained in the proverbial woodshed. NASDAQ suffered its steepest one-month decline (-13.24%) since October 2008, with April ensuring the S&P 500 is off to its 3rd worst year to date (-12.92%), with only the auspicious years of 1932 and 1939 having been worse. Here at home, the total return loss of -4.96% pushed the TSX into the red for 2022. For investors, the timing could not have been worse given equities as a percent of U.S. household assets stood at an all-time high of 41.9% at year-end 2021. The combination of rich valuations and fears towards inflation and growth, catalyzed this rout.
Driven largely by an influx of systematic capital flows during the back half of the month and a belief the Omicron-related Q1 economic dip was transitory, equities had a strong March. Markets appeared to be unfazed by higher interest rates and inflation, with limited impact from the Ukrainian situation. Despite the continuing conservative positioning held by each of our two funds, the table below highlights that each fund generated a positive net return. While we can identify catalysts that could cause equities to move higher, the combination of rising rates and slowing economic growth causes our bias to remain towards protection. The Energy sector continues to offer the best opportunity for offence.
In our 2022 Outlook Commentary, we suggested policy accommodation had peaked last Fall such that markets would ultimately turn on investors as this year progressed, but in the short term, ample liquidity would enable stocks to be okay. We also wrote that our constructive outlook on energy commodities and the value versus growth factor style of investing would enable Canadian stocks to outperform U.S. equities. Then by mid-January, the Fed turned hawkish and ever since, most financial assets, especially U.S. growth stocks, have had a volatile and rough time.
Last Fall, we suggested policy accommodation had peaked and this inflection would catalyze a prolonged unwind of the multi-year outperformance of growth stocks versus value-based equities. This gradual process continued during the month of January. Then in last month’s commentary, we suggested inflation would be the key variable driving the outlook for the price of assets during 2022; an item that definitely remains the case today. Before delving into these stories and revisiting our outlook for 2022, let’s recap the tumultuous month of January.
December 2021 was a volatile month in financial markets, as the newly named Omicron variant entered our lexicon and FOMC Chair Powell turned hawkish, though, in the end, equities appeared non-plussed by either situation. The S&P 500 enjoyed its best December since 2010, while Canada’s TSX generated a total return of 3.06%. For the full year 2021, stocks had a banner year driven by the impact of fiscal and monetary stimulus on asset prices and a strong recovery in corporate profits. In reviewing the performance of the S&P 500, 434 issues gained for the year, 96 of which climbed more than 50%, seven declined more than 25% and all 11 sectors posted double-digit gains (up from seven in 2020, five of which posted double-digit gains). The top five performers accounted for 32.6% of the total return for the S&P 500, including Microsoft Corp (MSFT.US) at 9.7%, Apple Inc. (AAPL.US) at 8.1% and Alphabet Inc. (GOOG.US) at 7.4%. The one-year graph below highlights the negative correlation between the relative outperformance of growth to value (white line) stocks against 10-year bond yields (red line; note the inversion). This correlation remained strong until Q4 when the flow of funds, words from the Fed, and Omicron combined to disrupt this relationship.
Usually it’s March, but this year, thanks to Fed Chair Powell and Omicron, it was November that came in like a lamb and went out like a lion. Powell’s ‘broken record’ denial that inflation could become problematic, combined with the Fed’s ongoing printing of money, U.S. M2, up +37% since February 2020, a further +13% year-over-year in October, kept investors dancing into the 3rd week of November. As shown by the one-year indexed graph below, the big winners during this latest leg of the rally were the ‘macro cap’ tech stocks (white line). In fact, at the November peak in the S&P 500, the six stocks highlighted below accounted for 26.4% of the SPX and 50.7% of the NASDAQ-100.
Equities roared back during October 2021 as markets were comforted by temporary stop-gap bills on America’s debt ceiling problem, respectable U.S. economic data, improving COVID-19 trends and a generally better-than-expected start to the Q3 earnings season. While the month closed with investors enjoying the 59th all-time high for the S&P 500 year to date, two stories that dominated headlines were the stunning climb in yields on two-year government bonds and the relentless rise in the price of oil. We’ll discuss oil later in this note but for now, please review the far right of the graph below, highlighting rise in yields on two-year bonds during October. German bunds (yellow line) are on the left axis, other sovereigns are on the right axis. Clearly, markets are pressing Central Banks to hike interest rates.
Last month’s commentary stated that “we now view markets as being expensive, with an increasingly asymmetrical risk/reward outlook when peering out over the next 12 months”. The S&P 500 had been trading comfortably north of 20X forward EPS amidst signs that monetary accommodation had peaked and a material retrenchment in fiscal stimulus was forthcoming. Our investment team proceeded to tactically reduce the net exposure of each of our two funds, resulting in solid net gains for the month of September.
While the deck of cards that market participants base their investment decisions upon has remained constant since COVID-19 changed the global dynamic 18 months ago, continued reshuffling of that deck has catalyzed significant month-to-month volatility across asset classes, equity sectors and factors. Unprecedented levels of liquidity remains the dominant variable pushing equity indices higher, yet larger-than-expected rates of deceleration in the American and Chinese economies (please see graph below), combined with fears surrounding the Delta variant, caused the growth style of investing to continue to outperform value during August.