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Some Perspective on Recent Record High Closes

All three major stock market indexes hit a record on the same day recently on March 21st. Those three indexes are the S&P 500, the NASDAQ, and the Dow Jones Industrial Average. This was the first time all three indexes hit a record high on the same day since November 8, 2021. You might therefore be wondering about what this means for stock prices going forward. I know that some of you are wondering whether things can continue to go this well. And I also know that our human brains sometimes like to say very unhelpful things to us like “what goes up must come down”.

But let’s be clear, stock prices can always go down for any number of reasons. Another war, terrorist event, a bad inflation report, or some other unforeseen event could cause disruptions in markets. But when indexes hit record highs, it is not a bad or bearish signal by itself. In fact, it’s quite normal that markets and indexes repeatedly reach record highs during bull markets.

Brian Levitt from Invesco wrote in January: “The S&P 500 has hit 1,176 new highs since its 1957 inception.” (The total is obviously higher now.) He goes on: “That’s the equivalent of a new high every…14.3 days. History suggests that investors should expect the market to ascend to many new highs over their lifetimes, even if the path isn’t always a straight one.”

Admittedly, even I was surprised by this little factoid of a new record high – on average – every 14 days or so. We obviously had a difficult period during 2022 and much of 2023 where the S&P 500 went 104 weeks or about 728 days (approximately 500 trading days) without hitting a record high. But now our patience has been rewarded.

Speaking of averages, please remember that the S&P 500 – on average – “corrects” or goes down about 14% every year, even though it ends up positive about 70% of the time at the end of each year.[1] Corrections are healthy and normal, and I would anticipate some type of healthy correction eventually even if this bull market persists.

Bottom Line: There is a lot to like in this bull market. Nobody knows how far it runs, but a string of record-high closes doesn’t necessarily mean that stocks are overvalued. As always, stay patient, stay disciplined…and stay invested.

[1] See J.P. Morgan’s 2024 Guide to the Markets, page 14.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Marshall Investment Management, LLC, a registered investment advisor. Marshall Investment Management, LLC and Kirsch Wealth Advisors are separate entities from LPL Financial.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The information contained in this email message is being transmitted to and is intended for the use of only the individual(s) to whom it is addressed. If the reader of this message is not the intended recipient, you are hereby advised that any dissemination, distribution or copying of this message is strictly prohibited. If you have received this message in error, please immediately delete.

By |2024-04-02T17:09:32+00:00April 2nd, 2024|Uncategorized|0 Comments

The Little Engine That Could – Will Small Caps Rally This Year and Deliver?

When my kids were little, one of their favorite books was The Little Engine That Could. Against all odds, that Little Engine climbed the hill and pulled the heavy load over the mountain. It wasn’t always assured that the Little Engine would make it, but it got there. It kind of feels the same with smaller public companies in markets these days – often referred to as “small caps”.

The large company indexes have recently been hitting record highs powered by the so-called “Magnificent 7”.[1] Meta’s stock recently saw an eye-pooping one-day gain of over 20% when it posted blowout earnings numbers. It was apparently the largest one-day gain in the market capitalization of any one company in the market’s history (i.e., market capitalization is total shares outstanding multiplied by share price). Meanwhile, small caps continue to trail their large counterparts. These little locomotives are getting no respect. They remain about 20% from their all-time record highs. But they’ve been perking up, so I wonder if things are turning.

My sense is that small caps could rally strongly once the Fed begins cutting the short-term interest rate. This is not a prediction – as Mr. Market tends to make people look foolish when they make predictions. But there are reasons for small-cap optimism. According to Goldman Sachs, “January 19th marked the first time in history that the S&P 500 hit an all-time high while the Russell 2000 was in a bear market.” (emphasis added). They go on to note that this type of market action is historically positive for both small and large companies with small companies outperforming large companies.

There are various stated reasons why small caps are getting no respect. First, they rely on bank financing more than large companies, and their borrowing costs are higher than for large companies. In addition, large companies tend to hold up better in market downturns, and the risk of recession has certainly been on the minds of investors over the last couple of years.

Price matters, and my adult memory reminds me to be cautious around high valuations. The Magnificent 7 are currently expensive from a price-earnings standpoint. Their prices may end up being justified if earnings continue to impress. But they certainly are not a bargain at the moment – but small caps might be. According to John Hancock Investments, small companies are trading at an 18% discount to their historical price-earnings ratio over the last 20 years while the S&P 500 is trading at a 27% premium, driven in large part by large growth stocks.

I believe it’s important to always maintain exposure to small caps given their historic growth potential to outperform large caps. Plus, they can be effective diversifiers in portfolios. If the “soft landing” or even “no landing” scenario happens this year with the economy, I like the chances of small caps surprising to the upside and pulling the heavy load over the mountain. They might even do just fine in a mild recessionary environment if the Fed is cutting the short-term interest rate considering that they are already trading at a discount.

Bottom Line: if inflation stays under control and the Fed begins cutting the short-term interest rate, I like the potential of smaller companies to rally strongly. As always, stay patient, stay disciplined, and stay invested.

[1] Apple, Amazon, Alphabet, Meta Platforms, Microsoft, Nvidia, and Tesla.

By |2024-02-14T05:03:59+00:00February 14th, 2024|Uncategorized|0 Comments

Strong Rally at Year End – Have We Turned a Corner?

Both stock and bond markets rallied strongly the last two months at year-end. Even the beaten down small and mid-sized companies finally rallied, too (though they remain well below their all-time highs). Inflation is retreating, and the Federal Reserve has indicated that they will most likely begin cutting the federal funds rate in 2024. Regardless of whether we’ve turned a corner, it seems safe to say that the rate-hiking by the Fed is over.

You and I are following consistent principles while working towards our financial goals. It’s that time of year to recall why we do this and how we’re doing it.

Why We Follow Principles

  • We do not believe the economy can be forecast with much precision. A year ago, nearly every economic expert was calling for a recession in 2023. But the recession never came. Even the Federal Reserve, with over 400 Ph.D. economists on staff, was embarrassingly mistaken on its forecast of “transitory” inflation.
  • Likewise, investment markets cannot be consistently timed. We’re therefore convinced that the most reliable way to capture the long-term return of stocks (over 10% annually) is to stay invested at all times. Stocks have outperformed bonds and cash by a wide margin, especially net of inflation, which has averaged around 3% over long periods of time.
  • Stock ownership is the only asset class that truly captures the upside of human ingenuity and creativity. We know that the engine of wealth building in stocks is the compounding effect. We must never unnecessarily interrupt the compounding by trying to time markets.
  • Individual investors historically have underperformed their own investments because they oftentimes react to current events and make ill-timed investment decisions. Reacting most likely means that our emotions are involved. Unless our goals have changed, there is probably no reason to make significant changes to our investments. As my long-term mentor, Nick Murray, says, “Stocks are returned to their rightful owners during bear markets.” Please remember that for every pessimist/seller, there is an optimist/buyer purchasing that stock being sold by the pessimist.
  • The recent inflation is a good reminder that the only rational definition of money is purchasing power. While inflation initially depresses both stock and bond prices, stocks have historically (since 1926) beaten inflation by around 7 percentage points on an annual basis – which is more than twice the amount earned by bondholders.

How We Do It

  • Planning. You and I are long-term, goal-focused, planning-driven investors. The best way to stay focused – and not react to current events – is to formulate a detailed financial plan and build diversified investment portfolios that match the goals set forth in our plans. We do not develop portfolios based on headlines, what’s “hot”, or some pundit’s view of the economy. A financial plan helps us understand that short-term price movements in markets are irrelevant to our long-term goals.
  • Diversify. We diversify by investing in a variety of stocks that include large companies, small and mid-sized companies, foreign companies, bonds, real estate, and sometimes commodities. Since Covid, diversification has admittedly been challenged at times (i.e., bonds in 2022). But diversification is generally effective because it helps us stay invested by smoothing out the highs and the lows of investment markets.
  • Cash and bonds for short-term goals. We always make sure that we have enough cash (and bonds) for near-term expenses not covered by other (retirement) income. This also helps us ride out the periodic stock market declines.

Current Observations

  • Interest rates. The Federal Reserve seems done raising the short-term rate. This is important for two reasons. First, the Fed is signaling flexibility that they will lower rates if recession strikes in 2024. The Fed has a dual mandate: stable prices and maximum employment. They’ve been deadly focused on price inflation for two years, but if the economy slows and hurts employment, then expect the Fed to lower rates. Second, the risk of the Fed’s strategy in raising interest rates aggressively has always been that the Fed would break something significant. And that would lead to a much larger problem beyond inflation. For these reasons, market participants have cheered on the news of the Fed pivoting.
  • Media. It’s an election year, so consume media at your peril this year. The media is not your friend. As Steven Pinker said, “The news is a nonrandom sample of the worst events happening on the planet on a given day.”
  • Earnings. Earnings in 2023 continued to defy expectations, and estimates remain strong for 2024.
  • Inflation. Nearly all of the inflation numbers are pointing positive. Some numbers might remain “sticky”, but it appears that the Fed’s work is mostly done on arresting inflation.
  • Productivity. This metric is difficult to measure, but it’s arguably one of the most important measurements of how we are performing as a nation. It measures how much more (or less) output we are producing per unit of input. That’s “geek speak” for how efficient we are at work. It’s almost hard to believe, but the Bureau of Labor Statistics reported that nonfarm labor productivity increased a whopping 5.2% in the 3rd quarter of 2023.[1] That’s a big number, and high productivity goes right to the heart of defeating inflation and raising living standards. Perhaps AI and other technological improvements are working their way into the data.
  • Government Debt. This is a problem, and it’s what most observers believe led to the interest rate on the 10-year U.S. government note reaching 5% in October. Auctions of U.S. government debt simply didn’t go very well last year. Therefore, the Treasury had to offer higher interest rates to attract more buyers of government debt. The U.S. Treasury recently switched tactics and is offering more shorter-term securities at auction to remove pressure from longer-term interest rates. For now, it’s working. The 10-year yield has dropped to around 4%. The other good news is that buyers seem to be more comfortable buying U.S. debt now that the Fed has pivoted and should begin cutting the short-term rate in 2024. If excessive government debt causes the 10-year bond yield to rise in 2024 to 5% or beyond, expect turbulence in stock and bond markets again. But the dollar and U.S. Treasury securities remain the gold standard in international finance.
  • Consumer Spending. Consumer spending remains robust, but there are concerns it will slow in 2024. Government “stimulus” payments, removal of student loan forgiveness, Social Security inflation increases, and temporary tax cuts are wearing off. Will this slow spending in 2024? Or will the Baby Boomers, who control more $78 trillion in wealth, continue to spend and power the economy?

Looking Ahead to 2024

As always, surprises can happen, and the world remains a dangerous place. But for now, there is a lot to like about investment markets and the economy going into 2024. Outside of the top 7 or 8 mega cap stocks that outperformed in 2023, stocks still look reasonably priced – especially small and mid-sized companies. Foreign companies have attractive valuations, too. Interest rates are back to more historical averages, and this should allow bonds to play a more constructive role in portfolios. For now, cash is yielding 5%, but expect that to drop as the Fed lowers the short-term interest rate.

The consensus view is that we are in the process of a “soft landing” coming out of this inflation mess – meaning that inflation returns to 2% without a recession. I am always deeply suspicious of the consensus view. But as the data points arrive, a soft landing certainly looks more likely than it did a year ago.

Bottom Line: The broad-based rally in stocks looks sustainable – or at least justified on current earnings estimates and declining inflation. There are always potential problems that could derail things, but the data looks promising. As always, stay patient, stay disciplined, and stay invested.

[1] U.S. Bureau of Labor Statistics, 12/6/2023.

By |2024-01-09T18:09:00+00:00January 9th, 2024|Uncategorized|0 Comments

Mid-Year Update – Stocks Surprise to the Upside

The pessimists have had plenty to talk about the last 18 months. Coming into 2023, the general consensus was that we were headed for recession, perhaps a nasty one, and that stock prices would remain under pressure. That hasn’t happened. If the Federal Reserve continues to raise the short-term interest rate, a nasty recession could still arrive. But it’s fair to say that the economy has handled the higher interest rates better than expected. We remain in difficult times, so before getting to Current Observations, let’s review the principles we’re following and how we do it.

Why We Follow Principles

  • We do not believe the economy can be forecast with much precision. Covid was the ultimate example of this. Even the Federal Reserve, with over 400 Ph.D. economists on staff, was embarrassingly mistaken in its forecast of “transitory” inflation.
  • Likewise, investment markets cannot be consistently timed. We’re therefore convinced that the most reliable way to capture the long-term return of stocks (over 10% annually) is to ride out their periodic price declines. In inflation-adjusted terms, stocks have outperformed bonds and cash by a wide margin – the math is powerful over time.
  • Stock ownership is the only asset class that truly captures the upside of human ingenuity and creativity. We know that the engine of wealth building in stocks is the compounding effect and reinvested dividends. We must never unnecessarily interrupt that compounding.
  • Individual investors historically have underperformed their own investments because they too often buy and sell based on emotions. As my long-term mentor, Nick Murray, says, “Stocks are returned to their rightful owners during bear markets.” Never forget that, for every pessimist/seller, there is an optimist/buyer for the stock trading hands.
  • We believe in continuously acting on a rational plan versus reacting to current events. If we are reacting, it most likely means that our emotions are involved. Unless our goals have changed, there is generally little reason to make significant changes to our investments.
  • The historical data underscores my conviction that the essential challenge to long-term successful investing is not intellectual, but temperamental. It is how one reacts, or chooses not to react, to stock market moves that ultimately determines our failure or success as an investor.

How We Do It

  • Planning. You and I are long-term, goal-focused, planning-driven investors. The best way to stay focused on the long-term is to formulate a detailed financial plan and to build diversified investment portfolios that match the goals set forth in our plans. We do not develop portfolios – or go to cash – based on headlines, what’s “hot”, market movements, or some pundit’s view of the economy. Planning helps us remember that short-term price movements in markets are irrelevant to our long-term goals.
  • Diversify. We diversify by investing in a variety of stocks that generally include small and mid-sized companies, foreign companies, bonds, real estate, and commodities. Diversified portfolios have been challenged at times since Covid arrived, but historically diversification has been very effective because it helps us stay invested by smoothing out the highs and the lows of investment markets.
  • Cash and bonds for short-term goals. We always make sure that we have enough cash (and bonds) for near-term expenses not covered by other (retirement) income. This helps us ride out the periodic stock market declines.

Current Observations

  • The recent rise in stock prices since last October has been a pleasant surprise. However, it has not been a broad-based rally. The large gains have mainly been concentrated in eight mega-cap technology stocks that investors believe will benefit from artificial intelligence. The NASDAQ index rose 32.7% in the first six months of the year while the Dow Jones Industrial Average rose only 3.8%.
  • Beginning in mid-June, however, the rally began to broaden. Potentially, this could be a very positive sign. Strong bull markets are generally not sustainable when only led by a small handful of companies.
  • All eyes remain on the Federal Reserve and whether they continue to increase the short-term interest rate. Inflation is clearly coming down, but the Fed continues its “hawkish” tone that they will keep at this until they feel that they’ve won the fight on inflation.
  • Here is a chart that should be getting more notice. It shows the 6-month annualized consumer price index (CPI) with and without shelter prices. According to Scott Grannis (and others), shelter prices lag the reality of the housing market by around 18 months – and shelter prices have been a huge driver of inflation over the last two years. If we strip out shelter prices, CPI is down to less than one percent (on this 6-month annualized basis). Yet, the Fed seems overly focused on the labor market as the principal driver of inflation. If we can get inflation down and raise wages without throwing people out of work, what’s not to like? So far, that doesn’t appear to be the thinking at the Fed.

  • The S&P 500 index dropped from 4766 to 3839 in 2022. That’s a drop of 19.4%. Further, the index bottomed out on October 14th at 3,583 for a drop of 24.8%. However, the companies in the index increased their dividend payout ratio by a whopping 15.4% last year.[1] In other words, 2022 was a fantastic year to reinvest dividends! – a high dividend payout ratio while stock prices were depressed. If you ever doubt the ability of stocks to fight inflation, keep this in mind: stocks in the index have, on average, increased their dividend payouts by 6.95% annually over the last 10 years. It’s a remarkably similar number over 20 years at 6.93%.
  • Earnings in the S&P 500 companies declined 2.8% in the first quarter. If we consider that, going into first-quarter earnings season, estimates were calling for a decline over 7%, the first quarter was an unqualified success. Companies are navigating the inflationary environment better than expected. Earnings reports for the second quarter start this week.
  • Compared to large companies, small and mid-sized companies continue to trade at very low “P/E multiples”. A “P/E multiple” is simply the price of the stock divided by the estimated earnings for the next year. Normally, small and mid-sized companies trade at a higher P/E given their ability to grow faster because investors are willing to pay more for that potential growth. According to Yardeni Reseseach, large companies are trading at a 19.0 P/E while small companies are at 13.2 and mid-sized companies are at 13.6.[1] I can’t tell whether it’s a buy signal from God, but I think it’s safe to say that this should eventually correct. And when it does, we could see a powerful rally in small and mid-sized companies.
  • We’re not hearing much about the health of banks lately. I still consider this to be a concern. But apparently merger and acquisition activity has picked up in the banking sector, and some experts are saying this should help firm up the weak areas of the banking system. Let’s hope they’re correct.
  • There has been much concern about how the U.S. economy will run out of steam once the government “stimulus” funds are spent by consumers. Well, maybe not so fast. I read an interesting piece from Yardeni Research discussing the amount of net worth owned by generation. The Baby Boomers own almost $75 trillion (with a T) of net worth, which is over half of the net worth in the U.S….and they are just starting to spend it. The Boomers are not the frugal Silent Generation. The net worth owned by the Boomers dwarfs the excess savings of roughly $0.5 trillion that remain from the pandemic.

Bottom Line: A “soft” landing in markets looks more likely, but the Fed could still spoil the recovery if they remain aggressive on rate hikes. In the meantime, stay patient, stay disciplined, and stay invested.

[1] https://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/spearn.htm
[2] Yardeni, July 2023
Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Marshall Investment Management, LLC, a registered investment advisor. Marshall Investment Management, LLC and Kirsch Wealth Advisors are separate entities from LPL Financial.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
The information contained in this email message is being transmitted to and is intended for the use of only the individual(s) to whom it is addressed. If the reader of this message is not the intended recipient, you are hereby advised that any dissemination, distribution or copying of this message is strictly prohibited. If you have received this message in error, please immediately delete.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
No strategy assures success or protects against loss.

By |2023-07-18T15:24:01+00:00July 18th, 2023|Uncategorized|0 Comments

The Good, Bad, and the Ugly Continue in Markets

The last 18-month period has probably been the most difficult economic environment I have seen in my adult life – if nothing else for the length of time that market forces have been battling each other.  As mentioned in a prior note, you are forgiven if you’re feeling some volatility fatigue.  But don’t despair, good things are happening, and I think we’re closer to the end than the beginning of this unpleasantness.

My job is to help you stick to your financial plan and investment strategy through the inevitable ups and downs of markets.  And not just stick to it – but stick to it with confidence and optimism.  My job is always to tell you the pure, unvarnished truth as best I see it.  And right now, whether you’re an optimist or a pessimist, there is plenty of evidence to support your position.  It’s impossible to list every event currently impacting markets and securities prices, but I list below the larger ones that I see impacting markets.

Earnings – Good

But let’s begin with earnings.  Corporate America appears to be doing a terrific job under difficult circumstances.  Many experts have been calling for a plunge in earnings…and so far, it still has not materialized.  It might still arrive – but first quarter earnings are nearly done and have again soundly surprised to the upside.  According to LPL, 79% of companies beat their analyst estimates (compared to a one-year average of 73% and the five-year average of 77%).  For now, earnings are only down 2.3% compared to the first quarter of last year.  Going into earnings season, estimates were calling for a more than 7% decline.  This is undoubtedly good news.

The Fed Appears to Have Paused on Further Interest Rate Hikes – Good

It certainly seems that they are pausing based on Chairman Powell’s last press conference.  He held open the option to raise rates again if the data deteriorates around inflation.  But his comments that he sees a soft landing helped markets rally last week.  Monetary policy works with a 12 to 18-month lag, so the worst of the tightening is most likely yet to come – and it’s possible we could even see rate cuts before the year is done to reverse the tightening.  The money supply (M2) has been shrinking over the last year.  While I believe this to be positive, it could turn into a negative if the money supply contracts too much.  The Fed has an awful track record at bringing the economy in for a soft landing, but it remains a distinct possibility.

Inflation Trend – Good

Overall inflation is clearly trending down (in line with the lags in the overall money supply).  The question is whether we will reach the Fed’s 2% inflation goal prior to something larger than banks breaking.

Employment – Good

It’s tough to have a “hard landing” when employment remains strong.  I understand that employment is oftentimes one of the last data points to hold up prior to a recession.  But the labor market is not currently showing any material signs of weakness.

Stock Prices in 2023 – Good and Bad

While markets are generally neutral to positive so far this year, the winners have been limited to a relatively small group of stocks – mainly large growth stocks.  This is not the sort of price action you like to see if we are to begin a new bull market in stocks.

Bank Failures – Ugly

Now for the ugly.  It’s possible the Fed has “ring fenced” this problem, but it’s reasonable to be skeptical.  Our system is based on confidence and trust, and bank failures don’t inspire either.  I understand that the banks which recently failed faced unique circumstances.  But there is a lot of commercial real estate that needs refinancing over the next few years. presumably at higher rates.  And depositors might continue to pull funds from banks to invest in money-market funds, especially if more banks fail.  Lastly, short-term rates remain high relative to long-term rates.  That’s normally not a great lending environment for banks.  Now, the converse is that most people will keep their money in the bank despite meager interest being paid on their bank holdings, and banks are lending at considerably higher rates.  The prime rate is currently 8%.

This is one of those stories that seems impossible to predict how and when more pain will arise.  After Silicon Valley Bank collapsed, the Fed made $650 billion available for lending to banks.  The banks borrowed all of it, and things calmed down.  Without question, banks are holding various amounts of impaired collateral – how could they not given the violent move up in interest rates?  By borrowing funds, maybe they were simply protecting themselves against being the next victim of a bank run.  But the cynical answer is that they’re in more trouble than we realize.  The colossal oversight by regulators over Silicon Valley Bank’s failure hasn’t inspired much confidence.  And remember – bailouts (i.e., setting up credit lines for borrowing) add to the money supply.  More bailouts could mean longer-lasting inflation.  Fingers crossed, but this story might not be over.

U.S. Debt Ceiling – Ugly

If history is a guide, our political parties will compromise and resolve this issue.  But this is one of those situations that could go to Ugly on steroids quickly.  A debt default simply cannot happen.

Conclusion

Even if we end up in recession, two things:  it doesn’t mean a market crash – arguably small and mid-sized companies have already priced in a recession.  They are trading at valuation levels well below large companies.  Second – and most importantly – we’ve done the proper financial planning:  therefore, we know we won’t need to liquidate stocks at losses to fund your goals.  Recession might still be on the way, but this is perhaps the most telegraphed recession in history, and that has given companies time to prepare.

Bottom Line:  Stay patient, stay disciplined, and stay invested.  Recession could lie ahead, but the longer we don’t retest the October 2022 lows in stock prices, I like our chances of crawling out of this mess sooner than later.

By |2023-05-11T17:53:58+00:00May 11th, 2023|Uncategorized|0 Comments

LPL Does Not Own a Bank – and What Happened at Silicon Valley Bank

After my last email on Silicon Valley Bank (SVB), I received several questions inquiring more specifically why SVB failed (and why are the other banks such a concern).

Before addressing that, I want to emphasize that unlike some other broker-dealers, LPL does not own a bank.  Any banking services offered through LPL are offered through contractual arrangements with outside banks.  Therefore, LPL does not have the same risk exposure that other banks and some broker-dealers are potentially facing.

The primary reason why SVB failed and why other banks are in the news is an old-fashioned, simple reason:  they borrowed short and loaned long.  This means they took depositor’s money (borrowed short) and bought long-term U.S. Government bonds (loaned money to the government…bonds are loans).

Unlike 2008, this situation did not involve toxic mortgage debt that was opaque at best.  It was simply a poor strategy of tying up capital in long-term assets when depositors could demand their money back at any time.

To be sure, all banks do this to some degree:  they take in depositor money and lend it out with the expectation of being repaid over time.  But based on what has been reported, this situation was extreme.  The bank simply took on too much risk.  The modern-day bank run can now take place online with a few clicks of the keyboard.  Throw in social media where news travels fast and the takedown of SVB was quick.

As for the bonds owned by SVB, investors generally receive a higher yield (interest payment) on a long-term bond, but these bonds are more sensitive to interest rates.  There is an inverse relationship between interest rates and bond prices: if rates go up, bond prices go down (all other things being equal).  Longer-term bonds (i.e., 10-30 years) are hit hardest.  Using simple bond math, the worst of the long-term bonds in SVB’s portfolio probably went down 25% to 45%.

Now, if SVB could have held the bonds to maturity (10-30 years), then the bond would be redeemed by the U.S. Treasury at its “par value” – no principal loss to the bank.  Or, if interest rates were to drop substantially, then the drop in rates could erase the loss.  But when depositors show up demanding cash, banks can’t wait.  SVB had to sell bonds at a loss to pay their depositors, and it became quickly and painfully obvious that they were in trouble.

Another problem for SVB was their niche customer base, which was early-stage venture capital customers.  Apparently, a flood of cash came into SVB during the 2020-2021 tech boom.  It was a perfect storm for SVB.

For now, it appears that the banking issues are contained.  The authorities have set up a couple of credit lines for other banks who might be facing trouble to borrow funds and pledge their securities as collateral.  Expect more headlines, but also expect a vigorous response should further trouble arise.

By |2023-03-30T16:00:55+00:00March 30th, 2023|Uncategorized|0 Comments

Volatility Fatigue…and Now a Bank Failure

The S&P 500 peaked almost 15 months ago and still remains nearly 20% below that peak. Moreover, the bear market in the more aggressive growth stocks began 25 months ago in February of 2021. Given those facts, you’re forgiven if you’re starting to feel some “volatility fatigue”.

And now the 16th largest bank in the country failed.

Where do things go from here? The honest answer is that it’s unknowable where they go in the short-term. But it’s good to see the authorities moving quickly to clean up the bank failure (though reasonable minds might disagree on the rather extraordinary move to guarantee all deposits. I am writing this on Sunday evening, March 12th.)

As we all know, the Federal Reserve has aggressively hiked the federal funds rate in a short period of time to fight an inflation that was caused by fiscal “stimulus” and loose Fed monetary policy. By moving aggressively, my fear has always been that they were going to “break something” significant which leads to an old-fashioned financial panic whereby trust evaporates and liquidity vanishes. Things change, but human nature doesn’t. While we are a long way from a financial panic, it’s worth paying attention to this bank failure.

For those who read these emails, you know that my message is one of relentless, sincere, and passionate optimism on our investment markets. I remain committed to that message as the only sane and responsible way to interpret our system. The modern capitalist system offers individual investors a tremendous opportunity to build large amounts of wealth if they simply play by some basic rules. Over a lifetime, work hard, save, invest in stocks for long-term goals, and don’t let fear infect your investment decisions. That’s the basic formula.

While I remain in the optimist camp, I have an adult memory that tells me additional caution is warranted going forward. Consequently, your volatility fatigue may worsen before it gets better. Prepare yourself. As the cliché goes, it’s darkest before the dawn.

It’s natural to feel intense emotions, but we cannot – we must not – let fear cause us to make mistakes by selling near market bottoms. Fear will lie to you: it’s different this time, don’t be dumb, protect yourself, sell now and buy later when it’s lower, the “smart money” is selling…and on and on Fear will lie to you.

These are the times when investors are tempted to commit large, life-altering, irrevocable mistakes. That is reason #1 why you’ve hired me.

Remember, we’ve done the proper planning to insulate us from short-term volatility by building cash and fixed income (bonds) into your asset mix. In fact, we routinely build in seven years of protection from stock price declines…seven years! We can weather this storm.

Markets will do what markets do, and we must have faith that the recovery will come sooner or later. In the meantime, the relentlessly efficient machine called Mr. Capitalism has now been summoned. As he always does, he must begin eliminating weak market participants. Eventually, cheap money always leads to excessive risk-taking and funds dumb ideas, and they must go. We’re hearing that the Silicon Valley Bank management took excessive risk and made dumb decisions, so they must go.[1] Others will surely follow.

Reasons for Optimism

The only definitive signal firmly indicating recession is the “inverted” yield curve (short-term interest rates are higher than long-term rates), and that’s not always predictive. In contrast, the money supply has leveled out and even contracted some in the last year – this will continue to reduce inflationary pressures. For now, credit spreads remain narrow[2]- and credit spreads are an outstanding indicator of recessions. The “stress index” put out by the Federal Reserve remains low.[3] Corporate profits, while showing some weakness, are mostly hanging in there, and estimates for the back half of this year into next look encouraging. And the January data generally surprised to the upside. The recession might be coming, but these data points don’t suggest it. And even if the recession eventually arrives, corporations and the consumer have had plenty of time to prepare.

The one good thing that will most likely come out of the bank failure – and this should be supportive of stock prices – is a Fed that slows down the monetary medicine and takes a more patient approach. I understand why they moved aggressively – they had no choice. But monetary policy takes a good 12 to 18 months to work its way into the system. The first interest rate hike in this cycle was March 17, 2022, and it was only .25% – so we’re just now tip toeing into 12 months. We probably have not seen the last of headline failures like Silicon Valley Bank.

Even if we are heading into a recession, please keep in mind that stock prices typically bottom well in advance of the economy hitting bottom. The consensus view seems to be that stock prices bottomed in October. Let’s hope so, but let’s acknowledge that our patience and volatility fatigue could be further tested, especially if we hit new lows.

Is the Long-Term Bull Market Still in Place?

For a market that has digested a tremendous amount of bad news, it certainly feels like stocks want to rally on minimal good news. I’ve been surprised at how little it has taken to spark markets to the upside at times. Here is my thought: I certainly cannot prove this to anyone, but the underlying market psychology seems to be one of optimism rather than pessimism. Even the bond market is pricing inflation at only 2.34% over the next five years.[4]

This is NOT a market forecast of any sort – but I wonder if we remain somewhere in the middle of a long-term “secular” bull market that has many more years to run. That could mean that we are currently in a shorter-term “cyclical” bear market. These secular, long-term markets play out over many years, usually decades, and are thought to be rooted in psychology. For a discussion on this, please see my blog post in 2021 or more recent articles here.[5]

Conclusion

For those of you who are still working and saving a portion of your income, revel in the glory of purchasing stock at lower prices. For those who have stopped working, revel in the glory of reinvesting your dividends at lower prices. And for those of you living off dividend income, the current environment is the primary reason why we implemented that strategy.

In closing, it’s worth recalling a Warren Buffet quote: “The stock market is a device for transferring money from the impatient to the patient.”

As always, stay patient, stay disciplined, and stay invested. Please do not hesitate to reach out if you would like to talk through any concerns, big or small. With sincere and deep gratitude, it is a continuing pleasure to serve you.

[1] Without getting too wonky, apparently their loan portfolio was concentrated in venture-capital firms, and they did not properly match up the timeline of their assets with their liabilities…violating the basics of banking.
[2] For a discussion on credit spreads, see www.investopedia.com/terms/c/creditspread.asp
[3] FRED St. Louis, 03/03/2023
[4] FRED St. Louis, 03/10/2023
[5] Markets Insider, 10/17/2022

By |2023-03-14T18:10:46+00:00March 14th, 2023|Uncategorized|0 Comments

Always Stick to Principles, Especially During Tough Times

As we all know, 2022 was a tough one for investors. Both stocks and bonds declined significantly. In fact, it was the worst year ever recorded for bonds. When times get tough, the statistics tell us investors are prone to making more mistakes due to emotions. It’s therefore helpful to remember what guides us in our financial planning and investing decisions to stay patient and disciplined. Here are the general principles you and I are following:

Why We Follow Principles

  • We do not believe the economy can be forecast with much precision. Covid was the ultimate example of this. Even the Federal Reserve, with over 400 Ph.D. economists on staff, was embarrassingly mistaken on its forecast of “transitory” inflation.
  • Likewise, investment markets cannot be consistently timed. We’re therefore convinced that the most reliable way to capture the long-term return of stocks (over 10% annually) is to ride out their periodic declines. In inflation-adjusted terms, stocks have outperformed bonds and cash by a wide margin – the math is powerful over time.
  • Stock ownership is the only asset class that truly captures the upside of human ingenuity and creativity. We know that the engine of wealth building in stocks is the compounding effect. We must never unnecessarily interrupt the compounding.
  • Individual investors historically have underperformed their own investments because they oftentimes buy and sell based on emotions. As my long-term mentor, Nick Murray, says, “Stocks are returned to their rightful owners during bear markets.” Never forget: for every pessimist/seller, there is an optimist/buyer for that stock trading hands.
  • We believe in continuously acting on a rational plan versus reacting to current events. Reacting most likely means that our emotions are involved. Unless our goals have changed, there is generally little reason to make significant changes to our investments.
  • The historical data underscore my conviction that the essential challenge to long-term successful investing is not intellectual, but temperamental. It is how one reacts, or chooses not to react, to stock market declines.

How We Do It

  • Planning. You and I are long-term, goal-focused, planning-driven investors. The best method to stay focused is to formulate a detailed financial plan and to build diversified investment portfolios that match the goals set forth in our plans. We do not develop portfolios based on headlines, what’s “hot”, market movements, or some pundit’s view of the economy. This helps us understand that short-term price movements in markets are irrelevant to our long-term goals.
  • Diversify. We diversify by investing in a variety of stocks that include small and mid-sized companies, foreign companies, bonds, real estate, and commodities. Though diversification was challenged last year, it’s generally effective because it helps us stay invested by smoothing out the highs and the lows of investment markets.
  • Cash and bonds for short-term goals. We always make sure that we have enough cash (and bonds) for near-term expenses not covered by other (retirement) income. This helps us ride out the periodic stock market declines.

Current Observations

  • Inflation peaked over the summer months and is now retreating in key areas. The money supply (called M2) exploded in 2020-21 when the government injected funds into a shut-down economy. Combined with supply-chain and other issues caused from Covid, this led to significant inflation (too many dollars chasing too few goods and services). But M2 has actually been shrinking since last spring – this is unusual but a necessary development if we are to get inflation under control.[1] The Fed was late, but at least they’re committed to arresting inflation. And this they must do, for inflation is an economic cancer that affects all of society and distorts how capital is invested. The impact of M2 takes about a year, so naturally we are now seeing inflation retreat – just as it took about a year from the M2 explosion to see inflation.
  • We’re all at least vaguely aware of the basic economics principle that prices are determined by supply and demand. To force down demand, the Federal Reserve has raised interest rates aggressively and relentlessly for nearly a year. We all think twice about financing the purchase of a new car or home when interest rates are higher. However, supply is different. The Federal Reserve cannot create more energy, more food, or anything else that is in short supply. In fact, the Fed should be careful on raising rates too high because that will eventually reduce supply. If you’re running a business, you’ll be reluctant to borrow money to create that supply.
  • The financial media is screaming recession for 2023 every chance they get as predicted by the “inverted yield curve” – this means that short-term interest rates are higher than long-term interest rates. Well, this could happen. If it does, so be it. I’m pretty sure an inverted curve has predicted eight of the last five recessions – or something like that. So we’ll just have to see how it plays out. In the meantime, I don’t see any reason to make wholesale changes to investment portfolios.
  • Inflation for goods has eased significantly. But inflation remains stubbornly high for services due to the tight labor market. Significant numbers of workers have not come back to the labor force post-Covid – and perhaps they never will. In the meantime, businesses must find ways with technology to improve productivity to get more production from their work forces. I remain optimistic that robotics, automation, artificial intelligence, and other technologies will play a key role here.
  • Earnings during 2022 mostly held up for the S&P 500 companies – and this ultimately drives stocks prices. When we receive the 4th quarter numbers, earnings should be up around 4% overall versus 2021. Clearly some sectors performed better than others, but the overall earnings picture for 2022 was an upside surprise considering the inflationary pressures. More importantly, earnings estimates for 2023 are expected to be positive again (though analysts believe earnings will contract slightly in the first half 2023).[2]
  • We now have a divided Congress. As an investor, I hope you regard this a firm positive. We tend to get more sensible legislation when both political parties work together. Markets like certainty, and it now appears that tax increases will not be enacted the next two years. Yes, some tax damage was done the last two years, but it could have been worse.[3]

Looking Ahead to 2023

If you’ve stuck with me to this point, I hope it’s clear that patience and discipline through planning is the key to long-term success – not the events that rock markets periodically. As I like to say – and, well, I stole this from somewhere – bad news happens fast while good news happens slow. And the media will make darn sure you get every bit of the bad news.

Regardless of what happens to financial markets in 2023, it will most likely have no impact on whether you reach your goals as long as we’ve done the proper planning and we stick to the plan. Regardless, such developments are not within our control. We can control how hard we work, how much we save, and how much we spend. Beyond that – and the planning – events are outside of our control.

But setting all that aside, here is how I think about things from a larger perspective: as long as we can freely own property, as long as the business community can write and enforce contracts in our court systems, as long as we remain relatively free from government intervention, and as long as people and businesses are rewarded for implementing great ideas to make our lives better, then I remain confident that our investments will carry us to
our goals.[4] So stated by your humble Optimist!

Thank you for your continued trust and confidence. It is a privilege and a genuine pleasure to serve you. As always, I welcome your comments, questions, and concerns if you would like to speak. We wish you and your family a Happy New Year!

[1] “FRED St. Louis Federal, December 5, 2022.
[2] Yardeni, January 9, 2023.
[3] Wallstreet Journal, January 3, 2023.
[4] I highly recommend the book Leave Me Alone and I’ll Make You Rich, by Deirdre Nansen McCloskey and Art Carden.
Securities offered through LPL Financial, Member FINRA/SIPC. Investment advice offered through Marshall Investment Management, LLC, a registered investment advisor. Marshall Investment Management, LLC and Kirsch Wealth Advisors are separate entities from LPL Financial.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
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By |2023-01-16T05:55:27+00:00January 16th, 2023|Uncategorized|0 Comments
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