News & Views

Still Work to Do for this Bear-Market Rally to Morph into a New Bull Market

Anything but a consensus view exists with respect to the probable future direction for stocks and bonds. To be sure, the latest two-month advance in risk assets caught more than a few bears by surprise. Short-covering almost certainly added frothiness to the July-August gains, but a 50% retracement of earlier 2022 losses provides a fairly solid base for positive momentum. For the lucky few that covered their short positions in the mid-June downdraft, though, post-2Q22 earnings season may offer an opportune time to re-short their most disdained stocks. After all, as the chart below from Yardeni Research shows, September historically provides the worst month for the stock market. What’s an investor to make of this environment?

Solyco Wealth continues to “ride the fence” with respect to choosing sides in this bear-bull tug-o-war. Starting six weeks ago we commenced over-writing much of our portfolios with covered calls that, generally, were at-the-money to +10% out of the money with respect to the underlying strike price. With early positive market momentum offering premiums of 1% to 2% for contracts of one month or less in duration, the risk-reward proposition appeared very attractive to us. In our view the option market still offers attractive risk management opportunities vis-à-vis company-specific medium- to long-term valuation forecasts and prevailing market conditions and, as a result, we continue to roll over most of these covered-call positions.

As we roll these options contracts, though, we remain hyper-cognizant of several key conditions that might signal conversion of this bear-market rally into a full-fledged bull market. We draw heavily on work performed by Ned Davis Research for this monitoring function. Key metrics include:

  • 90% of Russell 3000 stocks trading above their 10-day moving average (wide breadth of short-term positive momentum)
  • Advancing stocks outpacing declining stocks for the S&P 500 by a 2-to-1 margin for at least a 10-day period (persistent positive momentum)
  • Over 50% of Russell S&P 500 stocks setting new 20-day highs (ongoing duration of the move higher)

The strength of the move higher in a bear-market rally matters very little vis-à-vis the breadth and duration of the move higher. Markets threw investors more than a few head-fakes through the years with several past bear-market rallies in excess of 25%. The median gain for these largest rallies was 11.5%, according to Ned Davis Research, but with a median length of only 39 days before they fizzled.

As we view the other side of this fence we straddle, we also remain on the lookout for several phenomena crucial to gauging the probability of a swift and severe downturn. In our view downside data drivers likely will prove to be of a more fundamental nature than the obviously more technical characteristics we monitor for ongoing upside for markets:

  • Employment figures quickly deteriorating with resulting weakness in consumer sentiment and spending materializing
  • Inflation expectations re-accelerating to the upside which would imply the Fed will hike rates higher for longer
  • Corporate margins rapidly deteriorating faster than expectations due to labor, logistics, or raw materials pricing pressures (unlikely revenues decline in an inflationary environment)

Regardless of whether one views asset markets as in bear or bull phases, we counsel clients and investors to remain aware of the fact that attractive investment opportunities exist in all types of markets as well as through all phases of these markets. One need look no further than the 2022 price performances for the Energy and Utilities sectors and many of their component companies for evidence of this, as well as for several insurers and manufacturers.

Importantly, we maintain fundamental valuation discipline, particularly in frothy environments like we currently experience, and exit positions that look rich irrespective of the overall trend for risk assets. Notably, 11 of the 53 positions (20.7%) held across Solyco Wealth’s four model portfolios recently traded within 10% of our estimated values. We remain comfortable maintaining cash balances in excess of 10% in investment environments as volatile as that of 2022.

August Provides Prime Time for Financial Planning Review

The dog days of August offer prime time for financial planning and goal reviews. Sure, no one wants to consume vacation time with thoughts of budgets and investments and planning. The clearer heads that prevail when not consumed by work, however, provide optimal opportunities for focusing on such tasks. Maybe run through mental checklists while driving or sitting in the airport waiting for flight to board… work with me here: it will be to your benefit.

The review process need not be ridiculously time consuming and tedious. If it is, your process probably could use some help.  Please feel free to give us a call (713-444-3560), we are here to help. I recommend addressing three inter-related topics:

  1. Evaluate your budget
  2. Focus on your goals
  3. Consider you tax position

Just a guess here, but the unrelenting discussions of inflation omnipresent through the first half of 2022 likely impacted more than a few components of your budget. The costs of home ownership or rent, gasoline, and food almost certainly rose to levels significantly above expectations set earlier in the year. As a result of price escalations, savings and credit card balances may have suffered inordinately. Not to be a Negative Nelly and ruin your Bloody Mary buzz, but these could turn out to be big issues if the job market weakens later in late 2022 or in 2023 as the U.S. Federal Reserve continues to hike interest rates to curb that aforementioned inflation. Fail to plan, plan to fail – just sayin’.

My comments in the prior paragraph segue directly into this point: evaluate what changed from your last budgeting review to this assessment. Things likely changed for the good and the bad. If those two canceled each other out, “Hot dog!” order another Bloody Mary and quit reading. Higher probabilities exist that either “good” or “bad” outweighed the other through the first seven months of 2022. In this event what actions need to be undertaken before year-end 2022 to realign your means with your goals? Or, how do your goals need to be adjusted to improve your financial position and comfort level heading into 2023? Rarely do we suffer from poor planning when future events turn out to be better than our expectations. However, if 2023 underwhelms expectations how well positioned are you to attain peace of mind and endure until those rosier scenarios materialize?

Finally, it behooves one to complete at least one mid-year tax review to guard against surprises. A quick review of a paystub may confirm that deductions remain sufficient to avoid having to write Uncle Sam a check come April. Alternatively, a gap in tax withholding and a pay increase or mid-year retention bonus (good for you!) may present an opportunity to increase 401(k) contributions through the rest of the year or to open a Roth Individual Retirement Account (IRA). If you just go spend it, you keep driving more of that inflation that led this process in the first place, just kidding…not. Anyway, twenty minutes on tax planning could save you angst and a few thousand dollars down the road. I kid you not: a new client called April 10th last year to open an IRA after his accountant discovered insufficient tax withholding throughout the year. A quick review and the client could have leisurely pursued opening an IRA rather than hustling through the process and creating anxiety for himself and his wife. A little time here could go a long way later.  Happy August!

Big Week on Tap for Equity, Bond Markets

The week of July 25th not only is the biggest week for 2nd quarter earnings news, doubly important for showing how well (or not) companies fared through the tumultuous last three months as well as for how well they expect to do for the balance of 2022, but also for U.S. GDP performance for the last quarter and the Federal Reserve Bank’s decision on the degree it will increase its discount rate. Whew! This stacks a great deal of market-moving material in a compressed time period just before many take off for beaches, mountains, etc. for a much-needed August vacation.

Anytime this much news flow hits the wires volatility typically marks the only outcome forecastable with any degree of certainty. For those investors knowledgeable and comfortable using options to manage stock price volatility, weeks like this usually offer excellent opportunities to benefit from large premiums.

Even for conservative options strategies, such as overwriting core long equity positions with call options or employing cash-secured put options to either add to acquire long positions at lower price levels, we recently noted compelling premiums for select equities in Solyco Wealth portfolios. These premiums ranged from 1% to 2.8% versus near-money underlying stock prices with expirations less than one month away. Whether from the viewpoint of creating a synthetic dividend by writing a covered call or establishing a lower purchase price by selling a cash-secured put, we find such opportunities very compelling.

For more information on how Solyco Wealth may enhance your portfolios returns, please give us a call at (713) 444-2560 or drop us a message at ctrimble@solycowealth.com.  Thanks!

US Doing What it Can to Counteract High Gasoline Prices

High gasoline prices continue to plague efforts to lower inflation worldwide. The Russian invasion of Ukraine and the resulting sanctions prohibiting purchases of Russian oil substantially exacerbate tightness in world crude oil and petroleum product markets. As discussed below, markets dynamics foretold worldwide crude oil demand outpacing supply months before Putin’s ill-conceived attack. The Russia-Ukraine war and resulting market changes, however, wreaked such havoc on world markets that the US exported approximately 1.1 million barrels per day (Mmbpd) of crude oil and petroleum products on average over the past four weeks versus importing 343,000 barrels per day over the same four-week period a year ago. This ~1.5 Mmbpd swing to exports from imports represents a $20 per barrel to $30 per barrel swing in crude oil prices.

As shown in the following chart from the US Energy Information Administration, domestic crude oil inventories commenced declining rapidly in Spring 2021 (red circle). The prior six-week period, which saw significant additions to inventories of crude oil, marked the typical period of seasonal refinery maintenance when facilities shutdown and throughputs decline precipitously.

The graph below of US crude oil production exhibits a dip in flows from wells concurrent with refinery shut-in season, but with a corresponding rebound in production from 10.4 million barrels of oil per day (Mmbopd) in late March 2021 to well over 11.0 Mmbopd by July 2021. Production growth persisted until Fall 2021 when Hurricane Ida hit the Gulf Coast the final week of August, resulting in flooding and shut-in crude oil production. Unfortunately, demand growth persisted and crude oil inventories failed to recover through Winter 2021-2022, as shown in the above graph. 

Refineries, in order to meet burgeoning worldwide demand for gasoline, diesel, and petroleum products, only completed an amended turnaround in Fall 2021, as highlighted by the yellow circle in the following chart, negatively impacted by Hurricane Ida. As previously noted, this short turnaround for refiners offered no relief for the ongoing draws on crude oil production and inventories. This situation led to the initial increase in crude oil prices from the pre-Hurricane Ida $67 per barrel level to the $85 per barrel level in late-2021. Economically motivated, domestic US crude oil producers increased production year-over-year in 4Q21 to over 11.6 Mmbopd from 10.9 Mmbopd in late 2020. As shown in the above graph, these producers continued to increase production, albeit more ratably and conservatively than in earlier $100+ per barrel price regimes, to a recent 12.0 Mmbopd. Notably, oil drillers and oilfield services companies remained constricted by the same supply chain logistics snafus and lack of workers that complicated operations for much of the rest of the US.

Politicians and the popular press made much of declining refining capacity in the US. However, the above chart shows that refining capacity, again in response to high petroleum product prices, ran between 15 million barrels per day (Mmbpd) and 16 Mmbpd of throughput the entirety of the past 15 months, significantly higher than it ran over the prior year. Primarily in response to expectations for declining petroleum product demand, significantly higher expectations for alternative fuels and electric vehicles, and increased maintenance expenses, refinery throughput declined 8.6%, or 1.6 Mmbopd, from a peak of 18.0 Mmbopd in August 2018 to a recent 16.4 Mmbopd.

Very robust growth in gasoline and diesel demand brought on by the re-opening from COVID-related shutdowns, as shown in the graph above, combined with already very low crude oil inventories and long-term declines in refinery capacity provided a solid set-up for escalating crude oil and petroleum product prices months before Russia invaded Ukraine. With OPEC recenty producing 2.6 Mmbopd below its production goal in April and diminished spare production capacity, we do not see any quick fixes on the horizon other than conservation for high crude oil, gasoline, and diesel prices. In response to this opinion Solyco Wealth remains overweight the Energy sector, holding TotalEnergy, Schlumberger, Pioneer Natural Resources, Marathon Petroleum, and Earthstone Energy in its model portfolios.

Solyco Wealth Model Portfolios Endured 2Q22 to Maintain Outperformance Since Inception

While the 2022 downdraft for risk assets accelerated in 2Q22, the four model portfolios managed by Solyco Wealth remained, after fees, ahead of their benchmarks and the S&P 500 for seven of eight observations year-to-date (YTD) and since inception (SI). Year-to-date only the Conservative Model Portfolio, after a 0.50% fee, lagged its benchmark, doing so by 32 basis points (bps), or 0.32%. Performance after fees for all four portfolios– Conservative, Moderate, Moderately Aggressive, and Aggressive – exceeded that of the S&P 500 YTD led by the Moderately Aggressive Model Portfolio outdistancing the index by 809 bps, or 8.09%.

Stock-picking remained the driver of outperformance for Solyco Wealth across all time frames. The equity weightings in the portfolios, before fees, averaged exceeding the performance of the S&P 500 for the 2Q22, YTD, and SI periods by 32 bps, 397 bps, and 586 bps, respectively. Average returns for the fixed income holdings of the portfolios, by comparison, lagged those of the Bloomberg US Aggregate Bond Index by 336 bps for 2Q22, 103 bps YTD, and 47 bps SI, before fees.

Over the course of 2Q22, Solyco Wealth made very few changes to the four portfolios, consistent with the attentive portfolio management approach employed since the inception of operations on September 9, 2021. Across the four portfolios we reduced exposure to the Information Technology and Health Care sectors late in 2Q22, primarily by exiting positions in Taiwan Semiconductor, Humana, and Cigna, across the portfolios. Concurrently, we increased Industrials and Energy exposures with the additions of agriculture and construction equipment manufacturer Deere & Co. and petroleum refiner Marathon Petroleum. Over the course of more than three quarters of managing the portfolios, Solyco Wealth averaged making fewer than two changes to portfolio holdings per quarter. Holding approximately 30 total positions in individual equity and fixed income exchange traded funds (ETF) in each portfolio, Solyco Wealth remains committed to maintaining relatively concentrated, research-driven portfolios.

Conservative Model Portfolio

Returning (11.08%) YTD and (9.49%) SI after fees, the Solyco Wealth Conservative Model Portfolio YTD lagged its benchmark by 32 bps but exceeded it by 140 bps SI. As compared to the S&P 500, Conservative posted outperformances of 888 bps YTD and 575 bps SI. Equities in the Conservative Model led the S&P 500 across all time periods while fixed income ETFs in Conservative lagged the Bloomberg US Aggregate Index performance only in 2Q22, outperforming YTD and SI, as shown in a table on the following page.

Indicative of how poor 2Q22 was for stocks and bonds, only two holdings of the Conservative Model Portfolio posted positive contributions for the quarter: American Tower (+3.1%) and TotalEnergy (+0.5%). Amazon, down over 36% in 2Q22, defined the worst performer in the Conservative Model Portfolio. For the YTD and SI time periods Energy holdings Schlumberger and TotalEnergy remained the largest positive contributors to the portfolio as they have largely since inception.

Solyco Wealth Conservative Model Portfolio Comparative Performance: 2Q22, TYD, and Since Inception
    2Q22 Year-to-Date Since SW Inception
Benchmarks S&P 500 -17.41% -19.96% -15.24%
Russell 3000 -17.96% -21.10% -17.66%
MSCI All-World ex-US -15.85% -19.32% -20.92%
Bloomberg US Agg Bond -4.63% -10.35% -10.85%
Conservate Model Portfolio Portfolio -8.56% -11.08% -9.49%
Benchmark -6.38% -10.76% -10.90%
   +/- Benchmark -2.18% -0.32% 1.40%
   +/- S&P 500 8.85% 8.88% 5.75%
   +/- Equities vs. S&P 500 2.00% 3.88% 5.40%
   +/- Fixed Income vs. Agg -2.24% 0.31% 1.34%

The above table reflects a 1% annual management fee, or 0.89% since exception and 0.50% year-to-date through 6/30/2022. Actual client investment performance likely will differ from respective model portfolio performance due to several factors including: 1) Timing of securities purchases and sales, 2) Dividend reinvestment choices, 3) Securities held outside the model portfolio, 4) Weighting differentials for certain securities relating to whole versus partial share accounting, 5) Timing and pricing of rebalancing actions, and other minor factors.
Conservative benchmark = total returns for 10.0% Russell 3000 Index, 65.0% Bloomberg US Aggregate Bond Index, and 10.0% MSCI World ex-US Index and 15.0% cash allocations.

Moderate Model Portfolio

Returning (12.68%) YTD and (8.99%) SI after fees, the Solyco Wealth Moderate Model Portfolio outperformed its benchmark by 106 bps YTD and by 457 bps SI. As compared to the S&P 500, Moderate posted 728 bps of outperformance YTD and 625 bps SI. Equities in the Moderate Model fell below the S&P 500 in 2Q22 but led the index by 382 bps YTD and 797 bps SI. Moderate’s fixed income position lagged performance for the Bloomberg US Aggregate Index across all time periods: 287 bps in 2Q22, 60 bps YTD, and 3 bps SI.

Five equities in the Moderate Model Portfolio remained positive for the YTD and SI periods: Lockheed-Martin, Pioneer Natural Resources, Schlumberger, Traveler’s, and Vertex Pharmaceuticals. Amazon offered the stiffest headwind for Moderate’s performance. None of the eight fixed income holdings in Moderate offered a positive contribution YTD or SI, a testimony to the disastrous environment for that asset class thus far in 2022.

Solyco Wealth Moderate Model Portfolio Comparative Performance: 2Q22, TYD, and Since Inception
    2Q22 Year-to-Date Since SW Inception
Benchmarks S&P 500 -17.41% -19.96% -15.24%
Russell 3000 -17.96% -21.10% -17.66%
MSCI All-World ex-US -15.85% -19.32% -20.92%
Bloomberg US Agg Bond -4.63% -10.35% -10.85%
Moderate Model Portfolio Portfolio -11.46% -12.68% -8.99%
Benchmark -9.68% -13.74% -13.56%
   +/- Benchmark -1.78% 1.06% 4.57%
   +/- S&P 500 5.94% 7.28% 6.25%
   +/- Equities vs. S&P 500 -0.03% 3.82% 7.97%
   +/- Fixed Income vs. Agg -2.87% -0.60% -0.03%

The above table reflects a 1% annual management fee, or 0.89% since exception and 0.50% year-to-date through 6/30/2022. Actual client investment performance likely will differ from respective model portfolio performance due to several factors including: 1) Timing of securities purchases and sales, 2) Dividend reinvestment choices, 3) Securities held outside the model portfolio, 4) Weighting differentials for certain securities relating to whole versus partial share accounting, 5) Timing and pricing of rebalancing actions, and other minor factors.
Moderate benchmark = total returns for 22.5% Russell 3000 Index, 45.0% Bloomberg US Aggregate Bond Index, and 22.5% MSCI World ex-US Index, and 10.0% cash allocations.

Moderately Aggressive Model Portfolio

Returning (11.84%) YTD and (7.15%) SI after fees, the Moderately Aggressive Model Portfolio after fees outperformed its benchmark by 388 bps YTD and by 810 bps SI. As compared to the S&P 500, Moderately Aggressive posted 812 bps of outperformance YTD and 809 bps SI. Across all three time periods – 2Q22, YTD, and SI – the performance of equities in the Moderately Aggressive Model exceeded that of the S&P 500, driving 907 bps of outperformance SI. While Moderately Aggressive’s fixed income position lagged performance for the Bloomberg US Aggregate Index by 381 bps in 2Q22, contributions from the asset class YTD and SI outdistanced the index by 20 bps and 154 bps, respectively.

Tech holdings Autodesk, Applied Materials, and Advanced Micro Devices, and Cable and Entertainment companies Comcast and Paramount, each declined by more than 33% SI for the Moderately Aggressive Model. However, oil and gas producer Pioneer Natural Resources and lithium and fertilizer concern Sociedad de Quimica y Minera each generated 60%+ contributions to the portfolio. None of the eight fixed income holdings in Moderately Aggressive, despite exceeding performance of the fixed income benchmark index for two of the three displayed time periods, offered a positive return for any of the 2Q22, YTD, or SI, periods.

Solyco Wealth Moderately Aggresive Model Portfolio Comparative Performance: 2Q22, TYD, and Since Inception
    2Q22 Year-to-Date Since SW Inception
Benchmarks S&P 500 -17.41% -19.96% -15.24%
Russell 3000 -17.96% -21.10% -17.66%
MSCI All-World ex-US -15.85% -19.32% -20.92%
Bloomberg US Agg Bond -4.63% -10.35% -10.85%
Moderately Aggresive Model Portfolio Portfolio -13.02% -11.84% -7.15%
Benchmark -12.14% -15.72% -15.24%
   +/- Benchmark -0.88% 3.88% 8.10%
   +/- S&P 500 4.38% 8.12% 8.09%
   +/- Equities vs. S&P 500 0.99% 6.40% 9.07%
   +/- Fixed Income vs. Agg -3.81% 0.20% 1.54%

The above table reflects a 1% annual management fee, or 0.89% since exception and 0.50% year-to-date through 6/30/2022. Actual client investment performance likely will differ from respective model portfolio performance due to several factors including: 1) Timing of securities purchases and sales, 2) Dividend reinvestment choices, 3) Securities held outside the model portfolio, 4) Weighting differentials for certain securities relating to whole versus partial share accounting, 5) Timing and pricing of rebalancing actions, and other minor factors.
Moderately Aggressive benchmark = total returns for 32.5% Russell 3000 Index, 25.0% Bloomberg US Aggregate Bond Index, and 32.5% MSCI World ex-US Index, and 10.0% cash allocations.

Aggressive Model Portfolio

The negative returns YTD (17.02%) and SI (13.58%), after fees, generated by the Solyco Wealth Aggressive Model Portfolio provide direct evidence of the abhorrent environment for investors in 1H22 as Aggressive still outperformed its benchmark by 168 bps YTD and 432 bps SI and the S&P 500 by 294 bps YTD and 166 bps SI. The 5% of Aggressive allocated to Fixed Income, equally divided between short-term high yield bonds and emerging market government debt, lagged the Bloomberg US Aggregate Bond Index by >400 bps YTD and SI. Performance for Aggressive’s equities, however, continued to outpace that of the S&P 500 by more than 1% in 2Q22, 6% YTD and 9% SI.

Although the 65.1% SI return for Earthstone Energy continued to pace the Aggressive Model Portfolio, that stock declined 28.5% in the final month of 2Q22. Oilfield services leader Schlumberger, a 30% positive contributor SI, similarly saw its shares give back 25.5% in June 2022. These moves lower substantially undermined Aggressive’s performance for all time periods. Sociedad de Quimica y Minera with a +64% contribution SI and Vertex Pharma at a +46.6% SI return, however, positively contributed to the portfolio, which needed it to make up for the horrendous performances of Shopify (77.3%), YETI (55.3%), Paramount (38.4%), and Comcast (33.9%), to start 2022.

Solyco Wealth Aggresive Model Portfolio Comparative Performance: 2Q22, TYD, and Since Inception
    2Q22 Year-to-Date Since SW Inception
Benchmarks S&P 500 -17.41% -19.96% -15.24%
Russell 3000 -17.96% -21.10% -17.66%
MSCI All-World ex-US -15.85% -19.32% -20.92%
Bloomberg US Agg Bond -4.63% -10.35% -10.85%
Aggresive Model Portfolio Portfolio -17.29% -17.02% -13.58%
Benchmark -15.44% -18.70% -17.90%
   +/- Benchmark -1.85% 1.68% 4.32%
   +/- S&P 500 0.12% 2.94% 1.66%
   +/- Equities vs. S&P 500 -1.66% 1.79% 1.42%
   +/- Fixed Income vs. Agg -4.52% -4.03% -4.18%

The above table reflects a 1% annual management fee, or 0.89% since exception and 0.50% year-to-date through 6/30/2022. Actual client investment performance likely will differ from respective model portfolio performance due to several factors including: 1) Timing of securities purchases and sales, 2) Dividend reinvestment choices, 3) Securities held outside the model portfolio, 4) Weighting differentials for certain securities relating to whole versus partial share accounting, 5) Timing and pricing of rebalancing actions, and other minor factors.
Aggressive benchmark = total returns for 45% Russell 3000 Index, 5.0% Bloomberg US Aggregate Bond Index, 45% MSCI World ex-US Index, and 5.0% cash allocations.

Not for the Faint of Heart: Trading Tomorrow

Tomorrow marks the rebalancing of the Russell Indices on which many domestic equity market participants base their sector weightings, stock selections, and overall portfolio exposures. Given not only the overall turmoil in equity markets to start 2022 but also the major drivers of this disruption, this rebalancing season probably will result in some highly peculiar trading activity to say the least.

This probable outsized volatility comes on the heels of rather hectic trading last week, 6/13- 6/17. Last week culminated with Friday’s “quadruple witching,” which describes a trading day when stock options, stock index options, single stock futures, and stock index futures all expire at the close of trading. The lead up to quadruple witching likely drove heightened volume last week as the 645+ million shares traded of the SPDR S&P 500 ETF Trust (SPY) represented a 61% increase over SPY’s cumulative trading for the prior week. Thus far this week trading lagged that of last week, but wait and see what happens tomorrow (Friday, 6/24).

Among the peculiarities we will experience this coming Friday:  Meta [aka Facebook (FB)], Netflix (NFLX), and PayPal (PYPL), making their way into the Russell 1000 Value Index. Substantially reduced weightings in the Russell 1000 Growth Index for these three companies offsets the move to the value index. While the combined market capitalization levels of these three stocks at ~$640 billion falls well below what it did to start 2022, this move along probably will generate a few ripples in trading tomorrow.

The Russell 1000 Value Index overall will see a relatively significant reweighting from Health Care to Communication Services, which includes FB and NFLX, as shown in the following table below. Logically, an increase for the Health Care sector in the growth index supplants a reduction in exposure to the Communication Services sector. The magnitude of investment capital dedicated to value strategies thus far in 2022 dwarfs that of growth, hence the index movement of the above-noted once high-flying growth names FB, NFLX, and PYPL (among others).

My advice to those not inclined to move quickly in and out of their stock positions or that have yet to generate well-defined and well-thought buy-and-sell lists. Don’t watch. If you choose to watch, give the likely inexplicable market moves at least a week to sort themselves out.  Thus far 2022 already offers among the weirdest trading years on record. Try not to make it any weirder by falling victim to the technicalities of index rebalancing that themselves are only adjusting to 2022’s weirdness.

Set Your Expectations: Dynamics of and Rebounds from Bear Markets

A bear market for the benchmark S&P 500 came out of hibernation Monday (6/13) as the index breached the 20% loss level from its previous high January 3, 2022. Bear market conditions did not hibernate as long as usual this go around as only 22 months passed since the March 23, 2020, end of the prior, COVID-induced bear market, which only lasted a little longer than a month. This marked the shortest span between two bear markets since at least the Great Depression, as shown in the following table from S&P.

On average bear markets last a little more than 18 months. The most recent edition of bear market-dom defines the 15th iteration since 1929 of the unwelcomed phenomenon. This translates to the S&P 500 spending a little less than 25% of the time since the start of the Great Depression under bear market conditions, including more often than not from 3Q29 through 2Q49.

Looking for a little less dark-and-gloomy: the 12 post-1957 bear markets lasted on average a little over 12 months. The average negative return for these bear markets was 33%. Overall since 1957 the S&P 500 spent about 20% of the time trading through bear territory.

The following table, also from S&P, proves even sunshinier. It offers data on the timing and magnitude of recoveries from bear market conditions since 1957. This table excludes the 1990 bear market as that one only touched the 20%-decline condition. For the resulting 11 bear market recovery observations, the S&P 500 averaged 1% a week later, 3% after a month, 4% 6 months later, 15% after a year, and 30% 3 years later.

Only the Tech Wreck of 2001 remained negative 3 years after the onset of bear market conditions, albeit via a relatively very shallow, single-digit-loss ongoing drawdown. Probably more important for sanity at this point in the cycle, however, is the fact that for 77% of the time periods in the table above, or 49 of its 66 observations, the S&P 500 closed above its bear market level. The whipsaw of 2008, though, which saw mild positivity for a month after the arrival of the bear only to lose more than 25% over the next 6 months, offers a painful dose of potential reality. If solutions fail to eliminate the root driver of the negative condition causing the bear market, investors will continue to sell equities.

Inflation, Ugh.

Too much money chasing too few goods and services: inflation. Inflation is not a difficult concept to describe or to understand. Little Jill has an extra stick of gum that Jack would like to buy for a nickel. All looks good for Jack to enjoy a stick of gum until Billy, who also would like a stick of gum, arrives with a nickel and a penny he found on his walk over. Jill, ever the rational seller, agrees to sell Billy her last stick of gum for $0.06. Voilà, the Jill-Jack-Billy market for gum just experienced 20% price inflation.

The gum market balanced with just Jill and Jack involved, but Billy’s $0.06 – more money – unbalanced the market. If Jill’s mom happened to show up with another stick of gum – more supply – the market balances, providing both Jack and Billy still want a piece of gum. This balancing function that Jill’s mom provides in our very, very simple example represents what the US economy now sorely lacks, a balancing function.

This morning’s 8.6% annual increase in the U.S. Consumer Price Index (CPI) surprised – again – to the upside as compared to the consensus expectation for an 8.3% increase in year-over-year prices. The above figure from The New York Times offers a breakdown by major product and service category of the drivers of this 8.6% indexed figure. Unless you pulled a Rip Van Winkle and fell asleep for the past year, I’m sure you’re quite aware that gas prices at the pump, soft drink prices at the grocery, and clothing prices at the mall, all are higher along with the prices for just about everything else.

For any number of reasons, ranging from:

  • COVID shutdowns that limited production and transportation of goods and services,
  • Ukraine – Russia war that disrupted trade flows,
  • Insufficient workers to increase production of stuff and to serve consumers, and
  • Ineffectual government policies that further these economic imbalances,

the world cannot supply sufficient goods and services to satisfy demand given the magnitude of money available to purchase goods and services. This imbalance places outsized pressure on the US Federal Reserve, unfortunately, to reduce the amount of money available to purchase goods and services. Alternatively, consumers could choose to scale back their consumption of stuff. They could opt to save some of this excess money they currently chose to spend. Alas, it’s the job of government to do for the people what they cannot do for themselves and reduce consumption by decreasing the amount of money available to buy stuff. Enter all of the discussions about the Fed increasing interest rates and engaging in quantitative tightening, or reducing the amount of money flowing through the economy.

This is where it gets complicated, though. Everyone freaks out about the Fed raising rates too much and pulling too much money out of the economy. Exacerbating these fears concerning the Fed’s actions, the potential for consumers to come to their senses and start saving some of their money and not buying so much stuff. Doubling down on these problems:  provider of goods and services solve their issues and oversupply the market and have to fire some workers. What was a robust economy growing at an attractive rate with historically low unemployment goes off the rails and into a ditch. Ugh.

All of a sudden one begins to see why even the greatest economics PhDs screw this up. Solving inflation requires balancing an equation but with far, far too many variables of unknown interdependencies. In order to help these struggling, anxiety-riddled PhDs balance this inflation equation, a rational consumer – the main character of every economics textbook – might choose to walk more, drive less, go on a diet, turn off the A/C, open a window, and save some dough. Or not…

Dollar-Cost Averaging: Benefit from Volatility

Dollar-cost averaging provides investors a tool with which they may use volatility to their advantage. Properly employed, the process offers benefits for buyers and sellers of traded assets ranging from stocks to bonds, cryptocurrencies, sports bets, and collectibles. Trading costs, both in terms of effort and commissions, mark drawbacks to the method.

In purchasing or selling assets at various points in time and at various prices – the procedure described by dollar-cost averaging – market participants with longer term perspectives may manage short-term market dynamics. Consider the following example:

  • An individual investor wishes to purchase 1,000 shares of stock in a biotech company, we’ll call it Hypothetical Biovations (HYPO for short),
  • Hypo will announce its quarterly earnings before the market opens in three days, and
  • Management may (or may not) provide positive (or negative) results from a clinical trial for one of Hypo’s new drugs on their earnings conference call at 10:30 AM ET, an hour after trading opens for Hypo shares.

Our HYPO investor incurs several risk-points in pursuing their biotech investment, such as:

  1. Overall stock market volatility (beta) that may drive changes in HYPO share price irrespective of any specific company phenomena,
  2. Aversion or affinity within the investment community for the Healthcare sector or Biotech subsector of which HYPO is a member,
  3. Analysts’ analysis and opinions on the probability that HYPO will miss, meet, or exceed their expectations for the company’s quarterly results and/or future performance, and
  4. Views within the HYPO investment community on the potential success, or lack thereof, of the company’s new drug.

Utilizing dollar-cost averaging to potentially manage through this litany of risks – the other side of which are opportunities – might involve our HYPO investor buying a one-quarter (250 shares) position prior to any company-specific events. For the sake of adding specificity to our example, let us assume HYPO shares trade for $10 each upon our investor initiating their position for an outlay of $2,500.

Subsequent to this initial purchase, one of HYPO’s sell-side analysts decides to downgrade HYPO shares from Buy to Neutral a day prior to the company announcing quarterly earnings. In response HYPO shares trade 10% lower to $9 per share. The investor picks up another 250 shares at this $9 figure, resulting in a weighted-average price of $9.50.

Exacerbating this downside momentum, a day later HYPO just meets expectations for its quarterly financial performance. Also, management chooses not to mention any new drug developments in its earnings press release: shares give up another 10% and trade to $8.10 after the markets open. Our investor – eyes on the long-term prizes they expect HYPO to offer – picks up another 250 shares at $8.10 per share, bringing their average cost to $9.275 per share.

An hour later in management’s commentary concerning future prospects for HYPO, they mention the positive clinical trial results that our investor thought might materialize on the call. Shares on this news shoot 10% higher than their $8.10 low to $8.91 per share. Our investor rounds out their 1,000-share position at this $8.91 per share price, bringing their weighted average price per HYPO share to just over $9.00 (see table below).

Hypothetical Investment in Hypothetical Biovations (HYPO)

  Shares Price Incremental Investment Total Position Average Cost
Initial Trade 250 $10.00 $2,500.00 $10.00
Trade #2 250 $9.00 $2,250.00 $9.50
Trade #3 250 $8.10 $2,025.00 $9.03
Trade #4 250 $8.91 $2,227.50 $9.00

We’ll provide a positive ending to our HYPO example. Sell-side analysts’ upside revisions that incorporate their more robust expectations for HYPO’s new drug cascade through the market. As a result HYPO’s share price moves through the $10 level, leaving our investor with a tidy $1,000 profit vis-à-vis their $9.00 dollar-cost average-driven average weighted price as well as the $10 figure at which they initiated their position

Of equal potential value for investors considering employing dollar-cost averaging in their efforts, the method works for exiting positions as well. To illustrate this simply replace the “buy” related verbs in the above paragraph with “sell” verbiage: the figures remain the same. While our example employs a relatively short time frame of several days, driven by a specific event, the principle defining the prospective value of dollar-cost averaging in to or out of tradeable assets typically works over a wide range of timeframes and market conditions.

Why Downward Moves in Equity Markets Feel So Painful

Adages, aphorisms, sayings, and such gain popularity because they so often prove to be correct. A handful of my favorites:

  • The market can remain irrational longer than you can remain liquid.
  • This time it’s different.
  • Bulls make money. Bears make money. Pigs get slaughtered.
  • The market is a discounting mechanism.

With this missive I’ll focus on the last maxim: the stock market as a discounting mechanism. Equity markets in 2022 increasingly discount an impending recession. The drivers of this phenomenon range from supply shortages and logistical challenges driving outsized inflation to war, pollical strife and gridlock. Regardless of which of these factors most influences asset prices, their cumulative impact on sentiment probably exacts the most meaningful effect. The fact that negative sentiment commences to outpace fundamental factors really should not surprise investors, but it does so…repeatedly.

The following graphic from Morningstar details the degree to which the precipitous equity market downturn of 2007 to 2009 (black box) substantially outpaced the fundamentals of the S&P 500 (green box) over that period of time. While S&P 500 fundamentals deteriorated 17% over this period, the total return for the Index declined 58%!

Recent research from Credit Suisse First Boston detailed a similar relationship between equity market activity to start 2022 and fundamentals (see following table). Whereas the median S&P 500 stock price dropped 24.4% since its peak level, S&P 500 earnings expectations increased 3.3%. The breadth of this expected earnings improvement remained broad as all eleven sectors posted improvements in their earnings prospects.

Obviously, the market discounts not earnings growth, but rather significant and painful earnings contraction. The massive money-making opportunity here exists in determining which discounting component is wrong: prices or earnings forecasts. My guess is that it will prove to be a little of both. As such, I prefer to err on the side of picking companies with more easily trackable earnings (Energy and Materials, for instance) and with large and established bases of operations (like Microsoft, ServiceNow, Cigna, and Humana).