In the words of Jerry Seinfeld

I wrote a blog post on May 8 titled "Here's a TIP" that dealt with inflation and D&A strategies.  It was a bit dry and some of you may not have read it!  So, in hoping that I could make the topic more engaging, I asked our new artificial intelligence (AI) friend CHATGPT to re-write it in the words of Jerry Seinfeld! Take a read below!  I think you will find it entertaining since it capture the essence of what I was saying with a bit of comic spin:

So, let's talk about inflation. You know, that sneaky little thing that makes your dollar bill feel more like a coupon? Yeah, that one. People always say, "Hey, if you want to hedge against inflation, buy gold, buy commodities, buy equities." But you know what else they say? They say, "Hey, don't forget about TIPS!" No, not those little nuggets of wisdom your grandma gives you. I'm talking about Treasury Inflation-Protected Securities.

These things are like regular bonds, but with a twist. They're issued by the U.S. Treasury, so you know they're legit. And instead of just sitting there collecting dust, their returns are adjusted to keep up with inflation. Pretty neat, huh? But here's the kicker: Turns out, they haven't been the superhero we thought they were in the fight against inflation.

I mean, just look at the numbers! TIPS had some good years, sure, but when inflation peaked in 2022, they took a nosedive. Down 12.3% while inflation was up 8.0%? Ouch! It's like trying to fight fire with a water pistol.

And why did they flop? Well, it's all about the math. Low coupon rates, interest rate hikes – it's enough to make your head spin. Core bonds had it rough too, barely scraping by with a -0.1% average annual return. Talk about a close call!

Meanwhile, traditional inflation hedges like gold, equities, and commodities were out there flexing their muscles. They left TIPS in the dust, along with CPI (that's inflation, folks) and their dreams of being the inflation-fighting hero.

But hey, it's not all doom and gloom. There's a silver lining in this cloudy financial forecast. Turns out, diversification is the name of the game. Short-term bonds, high yield bonds, bank loans – they all held their own against inflation, and then some.

So, what's the plan now? Well, Dattilio & Ash aren't exactly rushing to buy TIPS anytime soon. But with interest rates on the rise, they might just become the belle of the ball. And as for gold? Well, hindsight's 20/20, my friends.

Instead, they're doubling down on core equities. Because let's face it, big companies know how to hustle. They're raking in those earnings despite the inflationary storm brewing. And sure, other equity diversifiers like REITs and international stocks might be struggling, but hey, a little diversification never hurt anybody.

So there you have it, folks. Inflation might be giving us all a run for our money, but with a little strategy and a lot of diversification, we'll come out on top. After all, it's not about how hard you fall, it's about how high you bounce back. And in the world of finance, that's the name of the game.

Here's a TIP!

Aside from the traditional inflation hedges like gold, commodities and equities, Treasury Inflation-Protected Securities (“TIPS) usually come to mind.  These securities are bonds issued by the U.S Treasury and are fully guaranteed.  They are different from regular bonds in that the total return earned from income and principal is adjusted to reflect inflation over the time to maturity.  How have TIPS done over the past few inflationary years in their role as an inflation hedge?

As we all know, the capital markets have all been up and down over the past five years.  What we may not have realized is that TIPS (TIP) have not been too effective an inflation hedge.  From the table below you can easily see that TIPS had a few good years and a few bad years; the bad years coming exactly when inflation peaked in 2022; actually DOWN -12.3% when inflation was up +8.0%!

The reasons for the underperformance have a lot to do with bond math and the low coupon rates that existed prior to interest rate increases that started in 2022.  That same phenomenon impacted core bonds (AGG) in a similar manner causing its average annual return over the entire 5.3-year period to be only -0.1%!  Over that longer time horizon TIPS did outperform core bonds, but not by much and certainly not enough to warrant an inflation hedge badge!

Also from the chart above, you can see that traditional inflation hedges like gold (GLD), core equities (IVV), and commodities (GSG) all handily beat TIPS and CPI (inflation) over that horizon. Interestingly, it is important to note that diversification in the fixed income universe paid off handsomely during this difficult period.

Aside from long term investment grade bonds (LQD) that have struggled in the face of higher rates, other fixed income sectors proved to be good diversifiers to help hedge inflation risk by outperforming core bonds.  Short-term investment grade bonds (SLQD), high yield bonds (HYG), and bank loans (BKLN) all outperformed TIPS and managed to stay close or beat inflation.  Some of that outperformance is due to a shorter bond duration and historically narrow credit spreads.

Dattilio & Ash has not been a buyer of TIPS during the prior market cycle. Higher rate levels today, however, may make TIPS a more interesting investment thesis going forward.  Gold, on the other hand, with 20/20 hindsight could have been a viable investment option over the past few years.  D&A had not been an investor in commodities due to their higher level of risk. 

Instead, we have focused mostly on core equities and shorter duration fixed income sectors and have consistently had total fixed income duration shorter than that of core bonds.  Shorter duration fixed income has less interest rate sensitivity and will outperform longer duration bonds when rates are rising in a Fed tightening cycle.

Core equities have been a good place to be as large stable companies are able to increase earnings due to inflationary pressures and D&A has been increasing allocations to this sector over the past several quarters.  Other equity diversifiers, like small- and mid-cap equities, real estate investment trusts (REITs) and international and emerging market equities continue to struggle to keep pace with core equities but we continue to hold for diversification purposes.

Video Blog - Market Views: A Long-term Strategic Assessment of the Capital Markets

In this 6-minute video blog post I highlight what the markets have done recently and over the past 10-years and discuss the relationships of risk and return of a few of the major asset classes.  I then integrate those thoughts into how we manage investment for clients.

Portfolio Management Decision-Making

I have written a lot about risk over the years and how it can influence portfolio management and market participant behavior.  For example, in 2022 many investors feared the developing market weakness and they “ran for the hills” by selling equities and buying bank CDs; thus, locking in losses and missing the huge recovery and new all-time highs in the broad equity markets.

Managing risk through portfolio management is as much an art as it is a science.  For a globally diversified portfolio and a given set of constraints, there are numerous approaches we could follow and many analytical tools (such as Portfolio Visualizer) we can use to help guide us with this task.  Let’s look at a few strategies that we could employ for a typical client.

Let’s assume you are a client with a long-term time horizon to retirement and want to maximize return as an aggressive investor with the capacity to accept a large amount of risk (20% standard deviation of returns).  Intuitively, we can guess that the target aggressive portfolio would be heavily weighted to equities with no fixed income allocation.  But, what exactly would this portfolio look like and what does the 20% standard deviation of return translate to?

Using the Portfolio Visualizer model, we can model expected results and get an idea of the details underlying these assumptions.  As you would expect, this aggressive model portfolio would generate large losses when the equity markets go down with a maximum drawdown of -30.16% but would generate a modeled expected return of +13.63% over a 10-year horizon (See table/chart below).  This portfolio targets the most aggressive sectors of the equity markets and is minimally diversified to help maximize returns; something a typical investor might not be comfortable with.   

Let’s say, however, that you are a bit risk-averse and instead want to target a lower moderate risk portfolio with a 10% standard deviation of return.  In that case, your fixed income allocation goes up from 0% to 26% and your maximum drawdown goes to only -16.13% with a modeled expected return of +9.37%. Interestingly, this modeled portfolio maintains a relatively large equity weighting, but this time it is allocated to the least risky equity sectors.

If you are somewhere in the middle, we can target a 12% risk and target a growth portfolio that results in a 10% fixed income allocation that generates a modeled return of +11.14%.  Again, this modeled portfolio targets the least risky equity sectors in lieu of a larger fixed income allocation to help reduce portfolio risk.

So, what does this all mean?  Models, after all, are only “models” and can only be used as a guide.  Quant investors, meaning those asset managers who rely on quantitative models to manage their portfolio, do NOT beat the market with any regularity over time so we know that models alone are NOT the solution.

There are literally an infinite number of combinations of equities and fixed income to create a portfolio with similar levels of risk, so SOMEONE needs to make an investment decision and invest in SOMETHING!  That is my job, as an investment adviser, to use my experience and knowledge of the markets to understand client objectives and goals to create an appropriate diversified portfolio with a target level of risk.

2024 Q1: Quest for "Normalcy"

Like a wilting flower, some of the bloom came off of the “Magnificent 7” during Q1 2024. Though Nvidia (NVDA) and Facebook (META) continued their phenomenal performance during Q1, the rest of the crowd came back to earth – and even struggled – with Tesla and Apple dropping -29.3% and -10.8%, respectively!  As the broad capital markets became more comfortable with the state of the U.S. economy, the S&P 500 (IVV) reached new all-time highs during the quarter and ended Q1 up +10.42%.  However, similar to previous rallies over the past few years, diversifying asset classes like small- and mid-cap U.S. equities and international and emerging market equities have lagged, but this time by a narrower margin. 

Though many imbalances remain in the U.S. economy, like housing affordability and pockets of unemployment, concerns about the U.S. economy are subsiding as inflation has fallen close to the Fed’s 2% target and growth remains strong.  Global tensions, however, are a crucial backdrop to market performance as the Russia/Ukraine and Israel/Hamas wars continue to cast uncertainty on the markets due to threats of supply chain disruptions and oil supply shocks.

Per the table above, we can see that most markets continue their recovery from the depths of 2022, with the S&P 500 (IVV) taking the crown for best performance.  Equity performance continues to be dominated by the “growth” story such that stable and mature companies, such as those in the dividend-payer space such as DVY, have not kept pace.  Fixed income has been a troublesome area with weak returns as the inverted yield curve works to right itself; long-end yields may rise as short-end yields may fall.

During Q1, I wrote blog posts featuring bitcoin, Nvidia and hydrogen; themed assets that are very topical with idiosyncratic profiles.  Though these all have potential for extraordinary return, they also have extraordinary risk per my blog post, Now What?  A Futurist View:

D&A believes in long-term strategic investing to help investors achieve their goals consistent with their time horizon, risk tolerance and special considerations.  The views of Cathie Wood are compatible with our philosophy as we both have a long term time horizon.  A fully diversified exposure to US and global equities will allow investors to capitalize on this view without adverse idiosyncratic risk exposure.

The Potential for Hydrogen?

Plenty has been written about clean energy since before Al Gore made his infamous documentary, An Inconvenient Truth, highlighting the effect of excess carbon dioxide on climate change.  A global push to reduce carbon emissions now exists and the emergence of a viable electric car industry is making an impact on our carbon footprint.

Most electric cars are simply cars powered by electricity stored in large batteries.  Other types of electric cars, termed hybrids, make use of small gasoline engines and electric motors that work in tandem.  But these are not the only types of clean energy cars.  A technology that does not get much publicity is electric cars powered by hydrogen fuel cells.

Hydrogen fuel cells produce electricity by converting hydrogen gas into electricity through a chemical reaction.  The technology is currently in use by some companies including Toyota but, despite its potential, has not gotten much traction.

Investors interested in this technology can participate by investing in exchange-traded funds (ETFs) that focus on this investment theme.  Three ETFs currently exist that cover this space: the Defiance Next Gen H2 ETF (HDRO), the GlobalX Hydrogen ETF (HYDR), and the Direxion Hydrogen ETF (HJEN).  As seen from the chart below, weak performance relative to the S&P 500 (IVV) has been the norm over the past 2.5 years.  Also, these hydrogen-themed ETFs have not attracted much investor interest since the combined assets under management for them continue to be well under $100 million.

There are a few ways to approach this from an investment perspective.  First, buy one of the themed ETFs shown above to get some exposure to the sector.  Another approach is to buy single-stocks that are thought to be market leaders in the space; a very time-consuming and laborious approach that does not guarantee success.

The biggest problem here, however, is that the macro picture is not very clear.  Despite all the efforts to push the clean energy agenda forward and potentially exploit the potential of hydrogen, there is still much to do and no guarantee on a time frame.  Just today (March 18), an article on CNBC highlighted comments from the Saudi Aramco CEO saying the “energy transition is failing” and the “world should abandon ‘fantasy’ of phasing out oil”.

Investing in hydrogen could be a viable strategy, but as of today it seems “too early”.  A lower risk approach to invest in this space is to wait for the markets to begin to show some strength based on some current growth and some firm growth potential before investing.  Otherwise, it would be prudent to stay fully invested in the broad U.S. large-, mid-, and small-capital equity markets and international exposure to have some exposure when/if that market develops.

Spot-on Bitcoin ETFs

We have all heard about cryptocurrencies and bitcoin.  The emergence of this “digital asset” has reached a new plateau of legitimacy given the approval of exchange-traded funds (ETFs) of spot bitcoins in January 2024; to date, about $10 billion has already flowed into these new ETFs!  Though bitcoin ETFs have been around since late 2021, those ETFs, were on bitcoin futures not on actual spot bitcoins.

Does this new development change the landscape for investors?  What can we expect going forward?

First, a quick description of bitcoins.  Bitcoins are digital assets created by digital miners using block chain technology and they only exist in cyberspace.  Bitcoins are scarce in that only a specified total volume of bitcoins are created.  Bitcoins can be thought of as an asset class that is traded amongst willing market participants, and even used as currency.  History has shown that bitcoin has a very high volatility making it a very risky asset class, but also with relatively low correlation to other asset classes.

You can’t hold a bitcoin in your hand.  Instead, you own it as an entry on your digital bitcoin account.  Owning bitcoin requires careful control of your account and passwords.  Though bitcoin adoption has been tremendous, some observers have felt that its growth has been limited by the perceived difficulty in holding it as an asset.  This is where the spot bitcoin ETF comes in!

Many market participants have likened bitcoin to gold as an asset class; “If you like gold, you will love bitcoin!”  Just like gold, bitcoin is a store of value and is a scarce commodity with limited supply.  However, unlike gold, bitcoin is easily divisible and tremendously portable.  Gold is difficult to cut into smaller pieces and certainly too heavy and difficult to transport.

Many market participants, including Mark Yusko of Morgan Creek Capital, have been huge proponents of bitcoin as an asset class.  His current market thesis is that the emergence of spot bitcoin ETFs have created a new and huge increase in demand for bitcoin as an asset class for market participants wanting some exposure by eliminating the difficulty in holding bitcoin.  Everything else being equal, the perceived increased demand given the limited supply leads him to a bullish view.

D&A has not bought bitcoin for any client accounts.  However, the advent of spot bitcoin ETFs may make it an acceptable diversifier for some aggressive accounts.  We will be following this market closely and report on it as our views crystalize.

Do you own Nvidia?

Nvidia, the current tech darling, has had a historic run and is now one of the best performing large cap stocks of all-time – up almost 400% over the last three years (see chart below, the green line at the top)!  This tech company, in the old days simply known for its high-performance graphics cards for gaming and video, found itself in an almost amazing business situation.  Perhaps serendipitously, Nvidia found itself with a chip architecture and design that made it perfectly suited for a multitude of new applications other than gaming!

The new applications started with crypto and crypto mining… then, it migrated to self-driving cars, other devices and robotics needing video recognition.  And now, the beginning of the AI revolution finds Nvidia with another large product niche that makes its chips highly in demand.

Combine this product demand with the very scalable manufacturing process of computer chips and you come up with drivers of both top line and bottom line growth.  Sort of analogous to a drug maker who finds out that its one drug cures not only headaches, but many other maladies – all while production is hugely scalable!!

If the bottom up and top down drivers of stock return are so bullish, why didn’t D&A buy it for its clients?  It is all about portfolio management and risk management!

D&A is philosophically committed to a globally-diversified risk-managed approach to portfolio management.  This approach precludes buying specific stocks that could expose portfolios to overweighted positions that could have an idiosyncratic risk profile, i.e., stock-specific risk.  For example, we are aware that Nvidia had a tough year in 2022 when it was actually DOWN -50%, but it recovered nicely in 2023 with an astounding +239% annual return.  Also, year-to-date in 2024 Nvidia has added another +46% return!  So lots of downside risk, but we have seen lots of upside risk, too!

D&A does believe that Nvidia should be a part of most investor portfolios, but only in a weighting that is consistent with a client’s risk profile and the broad indices that we follow.  For example, since Nvidia makes up 4% of the S&P 500, a client with a 30% allocation to the S&P 500 (IVV) would have a 1.2% allocation to Nvidia.  Additionally, since D&A believes in the momentum factor and invests in the iShares Momentum Factor ETF (MTUM) for some client accounts with a moderate/aggressive risk profile, since Nvidia stock makes up 6% of that ETF, a client with a 5% allocation to the MTUM ETF gains another 0.3% allocation to Nvidia.

So, most all D&A clients own Nvidia as part of the ETFs that we buy for client accounts; but only in an allocation that is consistent with the client risk profile.

Here We Go Again?

As readers of this blog are well aware, diversifying asset classes have had a difficult time beating core assets over the past few years.  Over shorter time horizons, such as during 2023 Q4, diversifiers have had some advantage, but we are starting to see large lags again as we enter 2024.

The S&P 500, once again overwhelmed by the performance success of the “Magnificent 7” – except for Tesla that has struggled mightily so far this year, is off to a good start.  The combined year-to-date (through Feb. 2, 2024) performance of Microsoft, Apple, Nvidia, Amazon, Meta, Alphabet, and Tesla that makes up a huge 27% of the S&P 500 is +9.1% compared to the S&P 500  (IVV) return of +4.0%.  The performance of key diversifiers like small cap (SCHA, -2.9%), mid-cap (SCHM, -0.4%), international developed equities (SCHF, -0.6%) and emerging markets (SCHE, -3.9%) pales in comparison.

So, what do we do?  Let’s look at the Callan Periodic Table of Investment Returns (see chart below) for a historical perspective.  As we can see, over the last 20 years the top annual performers were U.S. Large Cap (medium blue), U.S. Small Cap (dark blue), Emerging Market (orange) and Real Estate (red) with each taking top honors four times.  But, over the most recent last five years, U.S. Large Cap, i.e., the S&P 500, has been at the top three times!  And, over the most distant six years, Emerging Markets was tops three times!  The leader board has changed hands many times.

The idea, of course, is to have a well-designed mix of asset classes such that some “zig when the others zag”.  That has not been the case over the last three years with U.S. Large Cap being such a dominant leader.  Consequently, well-diversified portfolios over the recent past have actually LAGGED portfolios made up of less-diversified portfolios targeted only to the S&P 500. Can this go on forever?  History says NO, but we shall see.

D&A is a strong believer in a well-diversified portfolio targeted to an investors time horizon, risk preference/tolerance and special considerations to help meet their goals.   

Balancing Risk and Reward

Stocks or bonds?   Most people grasp the value of an equity position in a company.  In addition to the periodic payments of dividends, the value of the equity can also rise if the company or its prospects grow.  Just look at companies like Apple, Amazon, and Nvidia that have led equity markets with large returns over long time horizons!  Historically, broad indices of stocks (IVV) have produced annual total returns of about +10% over long time horizons.

 But, bonds seem a bit foreign to most people.  Though bonds start out looking like bank certificates of deposit (CDs) paying periodic interest payments with their principal value paid at the end of the term, they also can go up or down in value like stocks.  As we have seen, while interest rates were rising in 2022, core bonds (AGG) generated total returns of -13% while core stocks (IVV) were down -18%.   Over the longer term, core bonds have generated a total return of only about +3%. 

 If all we care about is “terminal value”, i.e., the value at the end of a chosen time horizon, and stocks generally outperform bonds, why buy bonds at all?  The answer lies with the definition of risk and the needs of the investor.

Interest rates from bonds today seem fairly attractive given the recent history of “ZIRP”, i.e. zero interest rate policy.  Short term Treasury bills currently pay a bit over 5% interest per year and longer term 10-year Treasury bonds pay a bit over 4%.  For a very risk averse investor, a 100% allocation to bonds today could help to generate about 4% annual total returns over 10 years.  Depending upon the specific needs of the investor, this could be a viable strategy.

However, for a young investor with a long time horizon and a good deal of human capital to earn income from their labor, they can generally accept more risk and can tolerate a larger equity content with more market volatility to potentially capture higher returns.

The chart below highlights the 16-year performance of core equities (IVV), core bonds (AGG), and three asset allocation funds with equity/bond allocations of 40/60 (AOM), 60/40 (AOR), and 80/20 (AOA).  As you can see, over this time horizon 100% core equities (IVV) led the pack with an annual total return of +10.5%, handily beating core bonds (AGG) with a total return of +2.6%.  As expected, as the equity content increased, total returns of the asset allocation funds increased with +5.7% for AOM, +7.5% for AOR, and +8.9% for AOA.

But, those higher returns came with higher risk from the equity component.  If you trace the green line (IVV, core equities), from its initial drawdown in 2008/2009 you can see that it took almost 5 years for its cumulative return to catch up to the returns from the 40/60 fund (AOM, gold line).  Also, the quantitative measures of volatility show much higher levels of risk for core equities (+20.2%) compared to core bonds (+5.5%) and the asset allocation funds.

D&A works with their clients to help determine an appropriate asset allocation and risk profile to help them meet their goals.  Some investors can accept more risk while others cannot wait five years for the markets to recover (like the green line above from 2008 through 2013).

Now What? A Futurist View

We just got through two very tumultuous years for the markets; down a lot in 2022, but up a lot in 2023.  The markets were bifurcated with defined winners and losers.  For example, techs were pummeled in 2022, but rallied strongly during 2023.   Certain sectors, including financials, struggled mightily without much recovery in 2023 due to the minor banking crisis in Q1 2022.

Also, prompted mostly by a hawkish Fed in 2022, bonds were down as much as stocks, but did not recover much in 2023 until the Fed signaled the potential to turn more “dovish”.  During the past two years the economy has resisted falling into a recession and inflation has receded nicely.  Additionally, all of this capital market behavior co-existed with troubling geopolitics and wars.  So, where do we go from here?  Do any “bets” make sense in this economic and market environment? 

There are plenty of forecasters (prognosticators?) out there.  We need to avoid “driving through the rear view mirror” so I favor the views of big thinkers who really look forward.  One such analyst is the (infamous?) Cathie Wood of tech investor fame.  She recently proffered her views of the future on a TEDTalk and it is well worth a listen on Youtube.

In it, she focuses on her identification of “five innovation platforms” that are evolving at the same time: artificial Intelligence (AI), robotics, energy storage, blockchain, and multiomic sequencing. The growth potential “reminds us of Amazon, 20-25% compound growth over 20-25 years” that potentially could be “sustained forever”.

One such revolution is the potential that exists in autonomous taxi platforms that converge energy storage, AI, and robotics.  The impact on transportation and business logistics is immense with “mid-boggling numbers.” Moreover, in her view, this productivity-generated real growth is disinflationary, if not deflationary.

In fact, Cathy Wood is blunt when she says she believes there is enormous productivity growth “the likes of which we have never seen” and “most people think we are crazy when we say things like this --- but we really do believe that real GDP growth around the world is going to accelerate from that 2 to 3 percent range into the 6 to 9 percent range and a lot of that will be productivity-driven.”

Ms. Wood closes with her final recommendation: “Get on the right side of change and hang on for the ride.  Because truth will win out and the opportunities are enormous.”

D&A believes in long-term strategic investing to help investors achieve their goals consistent with their time horizon, risk tolerance and special considerations.  The views of Cathie Wood are compatible with our philosophy as we both have a long term time horizon.  A fully diversified exposure to US and global equities will allow investors to capitalize on this view without adverse idiosyncratic risk exposure.

2023: Spotty Market Resilience

It wasn’t pretty and it wasn’t smooth, but in the end it mostly all worked out! A perfect scenario would include a longer term “catch-up” from all the broad diversifying equity asset classes; we shall see!

Certainly, 2023 was OWNED by the “Magnificent 7” (Apple, Microsoft, Amazon, Google, Nvidia, Tesla, and Meta) with a quick attempt at a catch-up during Q4 for everyone else!  Those 7 stocks overwhelmed the other 493 stocks in the S&P 500 with a combined +106% 2023 return helping the S&P 500 (IVV) close the year at +26.3%; just a smidge away from an all-time high!  S&P 500 performance, however, took a back seat during Q4 as small cap equities (SCHA, +14.7%) were best in Q4, with the S&P 500 still best for all of 2023; hopefully, the relative performance of small cap and other equity diversifiers can keep up the good performance into 2024 and beyond!

The economic backdrop and special factors in 2023 certainly supported this phenomenal recovery from 2022 (see table below).  It all started with a diligent Fed holding rates higher early in the year to help quell inflation.  Then, later in the year, economic statistics trended towards positive results with the Fed confirming a need to “pause” tightening monetary policy with a potential “easing” in 2024.  Combine this with the positive business dynamics of the potential for AI (artificial intelligence) to boost the tech business and potentially transform all businesses and there were plenty of reasons to cheer!  However, the troubling backdrop of raging geopolitics persisted including the Ukraine/Russia and Israel/Hamas wars.

The table above shows the relative performance of the major asset classes that I follow.  It is encouraging to see that all asset classes recovered mightily from the depths of Q3.  I reported back in Q3 that there were glimmers of hope for the markets including “mostly stable credit spreads in the bond markets, stable industrial production, stable unemployment, and rising consumer sentiment” but it seems that the Fed “pause” in Q4 was the impetus needed to propel all markets higher.

During the depths of Q3 when markets were struggling, it was easy for the negative market psychology to overcome rational thinking.  However, as I stated in my November 21, 2023 blog post, And Now For Something Completely Different!, some positive factors teased a recovery:

As it relates to the current market environment, we may be in the early stages of something modestly different in the form of an inflection point and some normalization of many of the key factors driving market returns.

"... An Inflection Point"

From my November 21, 2023 blog post, And Now for Something Completely Different!, I highlighted trends showing in several of my favorite factors that led me to think we are on the verge of a better market environment.  Prior to this, a negative bias certainly existed in the markets; and amongst some clients!

I noted mostly positive trends in factors including interest rates, inflation, unemployment, bond credit spreads, industrial production/capacity utilization and consumer sentiment and I stated that these trends “could be a positive sign for equities and fixed income”.  I cannot predict if the markets would go up or down, but the trends all pointed to the potential for a positive surprise.

Sure enough, the positive trends that were noted seemed to be confirmed by news on December 13 that the Fed could be done hiking rates and is contemplating cutting interest rates in 2024.

Certainly, “staying the course” was the right strategy to take and is paying off for D&A clients.  For example, the S&P 500 reached a new 52-week high today causing some cheer (see chart below)!  Also, many of the diversifying asset classes like small/mid cap equities and international developed and emerging market equities have rebounded nicely in Q4, but have more to go to catch up for their lag in all of 2023.

Fixed income, on the other hand, has been a good place for diversification since many of the sub-asset classes like preferred stock, high yield bonds, and bank loans, have done well in Q4 and all of 2023. Even short term bonds, that are now lagging long term bonds YTD, gave reason for cheer due to their superior risk-adjusted return.

I have been apologizing all year for the weak performance of the diversifying asset classes amongst the broad capital markets, excluding the Magnificent Seven, and have consistently stated that we need to “stay the course” and be patient because no one can “time the market”.

D&A conducted a few strategic tilts in most accounts that included improving the quality of equities and shortening bond duration – and then lengthening again, that helped improve the overall risk/return profile and help most accounts perform well against their benchmarks so far in Q4.  We are hopeful that it will continue into 2024 and beyond!

Round Trip Ticket?

I wrote about interest rates back at the end of October titled, “Timing is Everything!  In it, I reviewed the current Fed tightening cycle and how difficult it is to forecast interest rates, mostly due to the difficulty in understanding the timing lags implicit in every Fed action.

From the end of October (when I wrote that blog post) to now we have seen a dramatic swing in market interest rates!  Through July 2023, we had just seen 18 months of rate increases from the Fed causing short interest rates to rise precipitously from 0.25% to 5.50% and 10-year Treasury rates increase from 2.19% to 3.96% (see chart below).  Somewhat concurrently, the economy had started to show signs of slowing, thus prompting a thought that the Fed may be ready to end its tightening cycle to help quell inflation. Surely, a good time to lengthen duration!  NOT!

From August through mid-October the Fed skipped any more rate hikes while 10-year Treasury rates jumped to peak at 4.98%!  Though the causation is not clear, some economic statistics showed some strength that probably prompted fear of a resurgence in inflation with market participants now requiring an “inflation premium” to go out 10 years on the yield curve.  However, from that peak to now (December 6, 2023), we have seen the 10-year Treasury rate fall to 4.12%, thus implying a market view over that time horizon that the economy is NOT overheating, inflation is NOT accelerating, and the Fed is NOT likely to tighten again and, instead, is likely done with its tightening cycle and is preparing to loosen in the case where the economy begins to falter.

In perfect hindsight, from a total return perspective from July through December 6, 2023, one would have been indifferent to short versus long bonds since the total returns over this time horizon have been almost completely neutral (see chart below)!  In the fixed income world we just saw a classic “round trip” where a strategy of short or long bonds would have been a satisfactory investment strategy over that time horizon!  Short-term investment grade bonds (SLQD, the green line) marched slowly and sporadically higher in a narrow range, while riskier long-term bonds (LQD, the blue line) went on a wild ride ending up in the same place!

The lesson, of course, is to not try to time the market.  Maybe you could get lucky and time the bottom and top, but it is unlikely.  For long term investors, it is best to always stay diversified and plan for the long term!

And Now For Something Completely Different!

This catch phrase, from the British comedy show Monty Python, is clear in its directive that what we are about to see is completely different from what we have seen in the past.  In that show the results were usually absurd and ridiculous and were intended to elicit a chuckle.  As it relates to the current market environment, we may be in the early stages of something modestly different in the form of an inflection point and some normalization of many of the key factors driving market returns.

Following are several of my favorite economic and market indicators from the FRED (Federal Reserve Bank of St. Louis) website and what they are saying right now:

• Interest Rates – Fed Funds are still elevated based on the recent hikes to 5.25%-5.50%, but longer term rates like the 10-year Treasury have come down from a recent high of 4.98% to 4.40%.  Implies less need for inflation premium for investing to longer term and potential for Fed easing in future that could provide boost for equities.

• Inflation (CPI – Consumer Price Index) – At 3.23% in October 2023 it is down significantly from 8.93% in June 2022. Lower inflation that is closer to the Fed’s 2% targeted inflation rate implies the Fed is close to ending its restrictive monetary policy.  This could be a positive sign for equities and fixed income.   

• Unemployment – at 3.9%, a bit higher than recently but still well within trend needed for stable and strengthening economy.  Implies underlying strength of economy and purchasing power that will provide underlying strength in economic growth and could boost equities.

• Investment Grade Bond Spreads – At 121 basis points, down from 162 basis points in March and close to recent low of 119 basis points back in August.  Implies better financial strength for investment grade corporate bonds that could represent market belief that there is less risk premium in corporate credits implying corporate strength.

• High Yield Bond Credit Spreads – At 402 basis points, down from 450 basis points in October, but is still at elevated levels compared to recent lows of 380 basis points back in August.  Implies some strengthening financial condition of weaker companies, but is not as bullish as it could be.

• Industrial Production and Capacity utilization – Both have normalized over the past year; current levels show Industrial production index at 102.7 and capacity utilization at 79.5% (very close to the long term average); values implying normal levels without supply-push inflationary pressures. 

• Consumer Sentiment – Index has trended up to 67.9 compared to recent lows of 50.0 in June of 2022 and 59.0 in May of 2023.  Implies potential for consumer spending to increase from recent levels but could be more bullish.

So, plenty to be thankful for as we enter the Thanksgiving season!  Many of these factors are positive indicators for better days ahead, but many external geopolitical factors around the world and other economic and market factors could upset the apple cart.    

Stay the Course!

Mark Twain said, “if you don’t like New England weather, wait a minute”.  The same can be said for the capital markets!  For the 5 days ended November 2, 2023, the S&P 500 (IVV) is up +4.9%!  So, in 5 days you made just about as much as you would have earned in a WHOLE YEAR with U.S. Treasury bills!

Like I said in my October 15 blog post, What Should I Do?, no one can time the market and it is best to “stay the course”:

Finally, why not just sell everything and hold 100% cash at a current 5.50% yield for the next six months?  This could work if you had perfect foresight (no one does, of course) and don’t mind missing any upside when/if the market recovers…

As we all know, aside from the Magnificent Seven, dividend payers (mostly financials and utilities), small/mid-cap, and international/emerging markets have all struggled badly this year and detracted from account performance, but I am expecting that they will recover over time thus rewarding investors who “stayed the course!”

From the chart below, most of the underperforming diversifiers to the S&P 500 (IVV) had a similar rally.  Small- and mid-cap equities, international developed markets and dividend payers all performed comparably with returns close to 5% (except mid-cap that returned 4%).

Of course, there is no telling what the markets will do today (or tomorrow!), but because of these unpredictable blips in performance, it is always best to “stay the course”.  From a market study from the Hartford Funds, trying to time the market can be costly if you are out of the market when these blips occur:

If you missed the market's 10 best days over the past 30 years, your returns would have been cut in half. And missing the best 30 days would have reduced your returns by an astonishing 83%.

Timing is Everything!

Economics was my college major and I took almost every elective I could before I graduated.  Every day we are bombarded with economic statistics showing the current state of employment, inflation, interest rates, economic growth, etc. etc.  Sometimes the capital markets “like” the news and sometimes they don’t!  But, as my I learned from the Chief Investment Officer at my old firm, it turns out that “Timing is Everything!”

When the Fed announces a “tightening” to help fight inflation (usually not a good time to be in equities!), as they did in March of 2022, the goal is to help slow down the economy so that aggregate demand is decreased so that there is less upward pressure on prices (inflation).  But, and this is a big “but”, it takes some TIME for an interest rate hike to take effect on the economy – the initial impact is to see short rates RISE as the Fed controls the short end of the curve through the Fed Funds rate.

But, the impact on the long end of the curve (10-years and longer) is less easy to predict.  Initially, because there is inflation present in the economy, the impact on long rates could be for those rates to rise, too, because the market demands an “inflation premium” to entice purchasers of long-dated bonds.  However, a countervailing force that indicates an “expectation” of a slower economy and less demand for credit implies that long-dated interest rates will actually go down.  In this case, it is all about timing and the lag effect and how long it takes for the interest rate hike to cause rates to eventually actually decline!

As seen from the chart below from the Federal Reserve Bank of St. Louis, we have seen this dichotomy of interest rate movement play out during this market cycle.  When the Fed started raising rates in March of 2022, the impact was to push long rates up a bit initially (the blue line) and then continuing to trend up to follow Fed Fund rate increases (the olive and red lines) through the end of 2022 due to the inflation premium - an expectation of a slowing economy was not priced into the markets.

During mid-2023, rates began to moderate a bit due to some perceived slowdown in inflation, but this did not persist.  Continued increases in the Fed Funds rate into August 2023 showed a sharp increase in long rates to over 4% closing in on currently 5% thus implying that the markets continued to be less focused on an economic slowdown and more focused on more persistent inflation.

It is difficult to know what a “normal” yield curve looks like given the extreme low rates we have seen since the Great Recession in 2008 and difficult to gauge exactly how the equity markets and individual stocks will respond.  Certainly, except for the “Magnificent 7” that have defied most of the negative impacts during the economic and geopolitical turmoil of 2023, the bulk of U.S. stocks are struggling in the current environment.  For example, through today the YTD total return of the cap-weighted S&P 500 index fund (IVV) is +8.7% (due to overweighted inclusion of the Magnificent 7) compared to the equal-weighted S&P 500 index fund (RSP) of -4.1%.  Truly an extraordinary relationship!

There is an old saying about “not fighting the Fed” since they can control the short end of the yield curve and, ultimately, the economic environment; and interest rates levels do not necessarily determine equity returns (as we have seen with the Magnificent 7”!) No one can time the markets so it is always best to stay fully invested with a “tilt” to reflect the current environment.  Certainly, in this environment we believe that a higher quality equity portfolio (to weather a problematic economic landscape) and a shorter bond duration (to weather potential for “higher for longer” interest rates) is a prudent strategy until we return to a “growth” phase that will turn equities higher with normalized interest rates.

D&A Investment Soundbites

What have I said (and done) this year?  Following are some excerpts from recent D&A blog posts prefaced by a brief sound bite of our “truism”:

 1.     This was a great year for mega-cap tech stocks and a tough one for dividend-payers and others, but don’t think you can outguess the market and throw diversification out the window; you can’t!

https://www.dattilioash.com/our-blog/2023/10/15/what-should-i-do

As we all know, aside from the Magnificent Seven, dividend payers (mostly financials and utilities), small/mid-cap, and international/emerging markets have all struggled badly this year and detracted from account performance, but I am expecting that they will recover over time thus rewarding investors who “stayed the course!”

2.     Though D&A is a strong believer in long-term strategic investing, “tilting” portfolios away from targets to capture incremental returns is warranted when the underlying economics support a view.

https://www.dattilioash.com/our-blog/2023/9/19/forecast-foibles

As readers of this blog are well-aware, D&A is a long-term strategic investor favoring broadly diversified exposures, but is aware of market trends and will tilt portfolios to capture incremental returns when situations are warranted.  Such is the case in 2023 where excess cash in many portfolios was allocated into short term bonds and U.S. Treasury Bills yielding over 5% (annual); this is likely to continue and be expanded as we move into 2024.  Likewise, in some client accounts we have begun to overweight equity allocations into higher quality positions. 

3.     There are broad model portfolios of stocks and bonds that could meet some investor needs, but D&A prefers a customized approach to strive to meet client needs.

https://www.dattilioash.com/our-blog/2023/8/24/whence-inflation

D&A strives to manage investment portfolios designed to help clients achieve their goals.  Over time, allocations to stocks have been a good inflation hedge and bonds have been a good diversifier to smooth portfolio risk.  Each D&A client has a stock and bond target asset allocation customized to their risk profile as we strive to beat inflation over time.

4.     Though some individual stocks have done very well in 2023, it is very difficult to identify the winners ahead of time.

https://www.dattilioash.com/our-blog/2023/5/25/youre-fired-an-nvda-essay

Investing is a risky business and needs to be managed prudently to help clients achieve their goals.  Though NVDA has “knocked it out of the park” this year and has helped the broad U.S. equity market perform well as a component of the S&P 500, it didn’t always look that way back in 2022.  D&A strives to gain steady portfolio performance aligned with market benchmarks to counterbalance the risks associated with individual stock investments.

5.     As much as the past few years have not been too kind to diversified portfolios, D&A still believes in the approach and fine-tunes it as the markets rotate.

https://www.dattilioash.com/our-blog/2023/5/2/the-diversification-dilemma

So, I do not believe it is now time to re-write the textbooks and throw diversification out the window, but what do we do?  At D&A we are strong believers in long term strategic investing across a broad range of major asset classes and will continue to seek solutions to diversify client portfolios.  For example, last year we added an allocation of short term investment grade bonds (SLQD) to all client portfolios; we will do more of this kind of rebalancing over the near term.

What Should I Do?

When the markets don’t meet investor expectations, it is a normal reaction to second guess the chosen strategy.  Certainly, from my September 30 blog post title, “Where’s the Growth?, I highlighted many of the current negative factors leading to malaise in the capital markets (except, of course, for the “Magnificent Seven”) – not including the Israel/Hamas war that had not started yet!.  See chart below for a few of the Magnificent Seven (Apple, Microsoft, Amazon and Nvidia, the red line on the top) to see how they outperformed versus the S&P 500 (IVV, the green line on the bottom) on a year-to-date basis.

So, if you were NOT 100% invested in the Magnificent 7 this year, you may begin to wonder where your wealth should be allocated.  Alternative assets like hedge funds and private equity? Real Estate? Or maybe go to a casino?

Some sophisticated advisors will often suggest allocations to the alternative asset space as a way to add diversification and potential extra return to an investment portfolio.  This sometimes works and sometimes does not depending upon the market cycle.  For example, the $40 billion Yale endowment (which holds lots of alternatives) recently reported that their 1-year return ended June 2023 was +1.8% that significantly lagged a moderate risk diversified growth portfolio (iShares Growth ETF, AOR) that was up +9.0% over the same time frame.

Real estate is another place to go to diversify an investment portfolio.  Most D&A accounts have some exposure to real estate through the real estate investment trust (REIT) structure in exchange-traded fund (ETF) form.  Unfortunately, though the REIT market had some positive blips it has continued to struggle in the post-covid environment with only middling returns through today.  Single-property vacation homes and rental properties certainly rallied during the post-covid period, but gains seem to have peaked and fallen off during this current Fed tightening cycle.  Carry costs, the headaches of owning other property and idiosyncratic return profiles are negatives to this strategy, though.

Finally, why not just sell everything and hold 100% cash at a current 5.50% yield for the next six months?  This could work if you had perfect foresight (no one does, of course) and don’t mind missing any upside when/if the market recovers.  In some cases, when the quantum of investments is large enough and your time horizon is short enough, this may be the correct strategy, but for long-term investing it is a fools’ errand. You may as well just go to the casino!

No one knows where the market will go from here, but in this market cycle D&A has consistently been tilting most client accounts to higher quality and shorter bond duration during 2023 as we strive to avoid large drawdowns and provide some upside to client accounts.  As we all know, aside from the Magnificent Seven, dividend payers (mostly financials and utilities), small/mid-cap, and international/emerging markets have all struggled badly this year and detracted from account performance, but I am expecting that they will recover over time thus rewarding investors who “stayed the course!”

Where's the Growth?

Despite some phenomenal year-to-date strength shown by the “Magnificent 7” (Apple, Microsoft, Amazon, Google, Nvidia, Tesla, and Meta), the broad capital markets could not hold any meaningful strength into 2023 Q3.  A look at many of the key factors impacting capital markets shows that almost all of them have a negative bias for earnings growth and investment returns.

Some of the negative factors include rising interest rates, inflation still close to 4%, gas prices hitting 2023 highs, credit card debt at all-time high, Chinese properties under stress, possible U.S. government shutdown, record high bankruptcies in August, student loans start again in October, continuing Russia/Ukraine war, etc., etc.!  Nothing here necessarily portends a crisis; it would take some kind of “trigger” to get us into that situation, but the bias is decidedly negative.

A few positive factors like mostly stable credit spreads in the bond markets, stable industrial production, stable unemployment, and rising consumer sentiment do provide a pause for a “bull case”, but it is difficult to see the market going up from here.  Equity values are driven by earnings growth and with the overlay of negative factors there is not too much driving growth right now.

Within the context of relative value, a 5%+ risk-free rate from U.S. Treasury Bills provides investors a safe haven to wait out the storm.  This relative value play could be siphoning funds out of the equity markets but, since no one can time the market, a strategy to allocate all funds into cash is akin to a play at the roulette table.  Treasury Bills are a good place for emergency funds and for a portion of a bond allocation to reduce overall bond duration, but that is it!

As shown from the table below, we seem to be re-entering the “sea of red” that I coined during Q2 and Q3 of 2022 where all markets were big losers!  Except for short term investment grade bonds (SLQD) that I follow, all the major assets classes were down during Q3.  Notably, core equity holdings like the S&P 500 (IVV) have continued to outperform diversifying positions like small/mid cap equities and international and emerging market equities.

 Fixed income, on other hand, has benefited mightily from diversification with short-term investment grade corporates, high yield bonds, as well as bank loans and preferred stocks, all beating core bonds (SCHZ) on a YTD basis.  In fact, ironically, core bonds and core equity both generated negative returns of about -3.3% during Q3!

 Like I said in my blog post from August 2, 2023, Daring to Diversify, it is important to stay diversified to capture the risk premium embedded in the capital markets and strive to use equities in its role as a long-term inflation hedge:

The performance of various asset classes in July 2023 exemplifies the value of diversification.   …in contrast to the core S&P 500 index, several other diversifying equity asset classes, including small-cap (SCHA), mid-cap (SCHM), and emerging markets (SCHE), outperformed, delivering higher returns. This demonstrates that diversification can yield positive results even when the primary market index lags.…

While the S&P 500 has shown impressive recovery in 2023, it should not be the sole focus of investment. Including other major equity asset classes and strategies globally, as well as diversifying within the fixed income space, can provide a more stable and potentially rewarding risk/return profile. Investors should carefully consider their financial goals and risk tolerance when constructing a diversified portfolio to achieve long-term success.