• Equity markets have gone up 80% of the time when viewed on a 6-month rolling period. They have experienced 10% or greater declines over a 6-month period approximately 10% of the time.
• Of the worst downturns over the past 60 years, the market has recovered to its past high within 18 months… on average.
• Equity markets reach their low before the worst of the economic downturn.
• Emotional response to market volatility results in investors losing more than 25% of the market’s opportunity.
• The downturns do not necessarily lead to negative annual returns.

We have discussed the instabilities in the markets and the economy. We have been adding to our cash positions since Thanksgiving of 2021 as we looked to mitigate an expected adverse market environment. In the first quarter of this year, some questioned as to why we were not fully invested. Now that the major indices are down 20% to 30%, we are being asked why we are not fully in cash. The answer is we look to be approximately right rather than precisely wrong. To have the confidence to move to an extreme requires much more than a recession. It would likely require a banking crisis.

There is little doubt that the inflation wave we are experiencing and the fight against it will be painful. And the markets will have to reflect it. Which they are. Now.

Investment markets—both equity and fixed income—discount future events. When those anticipated future events are positive, no one questions that discounting. However, when the future becomes darker, the downward adjustments are not easy or graceful. When the market is finding its correct level, the changes are typically abrupt, halting, and clumsy. Of course, dramatic data and big swings between the ups and the downs can make people feel uncertain and out of control. The danger is when feeling like that brings people to act on fear and regret—regret that “I should have sold all of my portfolio in…”

Consider, however, that historical market movements have demonstrated the best time to buy (or sell) is when the opposite action would feel most comforting. Our models, based on pattern-recognition over decades, have been working, so we will continue to follow their unemotional and empirically tested direction.

We firmly believe that market bottoms and tops are processes and should not be viewed as discreet points in time.

“True security lies in the unrestrained embrace of insecurity—in the recognition that we never really stand on solid ground, and never can.”

“Uncertainty is where things happen.”

Over the past two long-drawn-out years, we have discussed the idea that market participants swing between uncertainty and complacency. We have also observed that most investors believe asset prices will be protected by central banks, a phenomenon pundits call the “Fed put.” Investors have had good reason to become complacent and believe in the Fed put because the past two decades have trained them to look to the Fed whenever asset prices drop materially. However, that was during an environment of low inflation, or even deflation, when the Fed had the luxury of acting without igniting an inflationary fire.

The Federal Reserve Bank of the U.S., or the Fed, the dominant central bank in the world, has two mandates: (1) maintain a stable value of the U.S. dollar by fighting off inflationary pressures, and (2) maximum employment. As we have presented over the past few months, the Fed had 40 years of deflationary forces—the Non-Inflationary Consistently Expansionary (NICE) period—that allowed it to dampen economic volatility and reinvigorate a bullish spirit through lower interest rates. And as the next recessionary threat came along, the Fed continued to lower rates because it worked so well the previous time. Investors have been trained like Pavlov’s dogs to gobble up more speculative (riskier) assets when the Fed rings the lower rate bell, and with asset pricing being higher than at almost any time since World War II, the dogs have gotten fat.

The sustained lower rates have reduced investors’ sensitivity to “here and now” cash flows, pushing them into higher risk, more speculative investments. What happens if the next bell to be rung is for higher rates?

We now sit at zero interest rates. Even more importantly, we are experiencing high inflation that could be argued is structural in nature rather than transitory. As uncertainty continues to build with war in Ukraine and an ongoing pandemic, many prognosticators look at the playbook of the last 40 years and assume the Fed will continue down that same path of low rates to protect asset pricing and reinforce speculation, pushing inflation control to a much lower priority.

That assumption seems excessively complacent from our perspective and suggests an anchor bias that could present issues into the future. The anchoring of one’s economic view to only the last 40 years omits the stagflation of the 1970’s and it’s impacts on discretionary spending, economic growth, and the rising uncertainty that plagued the investment markets. We sit with conditions that are far different than those over the past four decades. An underinvestment in energy production along with rising tensions between economic and military parties is a clear deviation from the inclusionary tailwinds experienced since the early 1980’s.

To shake off that anchor bias, we recommend Nassim Taleb’s book Antifragile, written in 2012. Antifragile, very haphazardly summarized, posits that most systems exhibit swings or variations due to system stress, and it argues that such stress, although uncomfortable, can help build long-term resilience and strength into the system. Some will see the “swings” as flaws, or system bugs, and will look to limit the system’s negative feedback. When the Fed moves to dampen economic volatility via lower interest rates, it is doing just that. And we are concerned that such efforts could lead to increased economic instability (which would also surprise many) once rates start trending higher.

Reducing the natural variation that stresses a system prevents adaptation and protects inherent flaws, creating fragility under the appearance of everyday steadiness. The ultimate result is a more chaotic eventual path when larger stresses that can’t be “managed” present themselves. The changing attitude to forest fire prevention presents a wonderful analogy. Today we ignite small, localized fires as a means of controlling undergrowth. The small fires remove latent fuel so that accidental fires have less fuel and are therefore easier to control. Several decades ago, however, the idea was only to prevent all fire, which meant larger, more fierce fires when they did come, which were uncontrollable and devastating to the environment.

In his book, Taleb argues that when large, uncontrollable events occur, there are not only some actors within the system that can withstand the turmoil, there are some that benefit from the periods of increasing fragility. He calls them the antifragile. More on this is a second…

As mentioned above, we contend that the last 20 years of Fed increasing actions to thwart the natural volatility within the economy and the markets have led to a perception of lower uncertainty built into the valuation process of risk assets. It worked because they had the inflation headroom to adjust rates lower. A whole generation of investors have been trained to see lower rates as a solution to market turmoil. We are increasingly concerned that the NICE period is behind us, and the Fed will be forced to focus on inflation fighting.

We are not the only ones discussing this conundrum and what it means for the economy and asset prices. Incremental investors are more and more on the lookout for antifragile assets while distancing themselves from fragile assets. By fragile asset we mean those that have their value arriving in the distant future rather than ones that generate (and protect) value in the here and now. Some recent phenomena suggest a move away from fragility. For one thing, growth stocks have come under increasing pressure. Also, blockchain instruments have been halved since the beginning of the year. And innovation stocks are down 60% to 80% over the past year.

One issue with defining anything as fragile or antifragile is that the definition will be dependent on the system one is looking at and the factors that drive it. What was once antifragile may turn out to be fragile under a different context. During the financial crisis, U.S. long-term sovereign debt was a safe haven. Can that be true in a rising rate environment? The jury is still out.

What we at Auour do know is that cash, the basis for valuing almost all assets, is likely to be antifragile if we see pricing of all assets needing to adjust to an inflation-fighting Fed. Our strategies currently hold roughly 25% cash as we continue to crave antifragility.

Let’s start with the idea that inflation is not fleeting, as hoped, but rather it’s becoming embedded in the economy. In our recent newsletter, we discussed the events leading to scarcity, and, we argued, they appear to be driven more by structural causes than by the money-supply. (Money supply has played a large role, but we think it merely amplified the underlying structural issues.) We sit in an unstable position, then, if you believe history is to be respected.

The chart above highlights this instability. The green line shows the long-term historical relationship between inflation and interest rates. The purple line depicts the same relation only for the period encompassing the pandemic. Even if you believe inflation (shown as “core CPI,” on the x axis) is only temporarily elevated, it still argues for a 200bps adjustment in the 10-year Treasury note—from its current 1.8% interest rate to something around 4%. (As an aside, interest rates on mortgages are traditionally tied to the 10-year Treasury interest rate. Could you imagine a world where mortgages were in the 5% to 6% range?)

The distortion is, as has been well-publicized, driven by the world’s central banks pushing down rates. They do so by purchasing government bonds as a means of propping up prices, which lowers interest rates. Their influence is demonstrated in the declining share of sovereign debt held in the hands of private investors, who traditionally are the natural buyers of fixed income instruments.

Global central banks outside the U.S. have been about the only buyers of sovereign debt for the past decade, blurring the distinction between central banks and political bodies. This suggests one of two paths: that central banks will stop buying sovereign debt, letting the private markets once again control the price of that debt and letting risk-free rates move to market-determined levels; or, that political will wins, central banks lose their independence, currencies risk their value retention and inflation continues to run hot.

Central banks, through their massive buying of debt, have created a blackhole in risk-free rates, drawing all income-producing vehicles into that hole. If central banks need to give up on an easy monetary environment to fight inflation, rates across all income-producing products will increase, leaving little opportunity for fixed-income instruments to appreciate. This has some market strategists arguing that more equity within a portfolio is necessary. However, in our view, that comes with its own set of risks.

The first among such risks is over-valuation.

No matter what metric you choose to measure equity values now, we are seeing historically high valuations. The above chart highlights the CAPE (cyclically adjusted price to earnings) ratio, which is horrible at predicting timing, but good at demonstrating severity when (not if) market participants return their focus to values-based investing. While it is true that the future might be different in unknowable respects from the past, the last 100 years of data should humble us all. The chart below looks at 10-year forward returns versus experienced CAPE. All 10-year forward returns from valuation levels near what we are seeing today have been negative. This is also true for 5-year forward returns. (These last two charts should look familiar because we have presented earlier versions before, and they continue to become even more extreme with updated data.) Extremes typically last longer than many expect, but that doesn’t make them any less extreme.

We are not arguing to avoid equities completely. Instead, we are highlighting the need for caution. The 10-year returns following high CAPE periods of the past come mostly from the dotcom bubble, and a few data points are from the late-1960’s. Many of us are not old enough to remember the 1970’s—the period that returned to valuation sensitivity, but a lot of us remember the 2000’s quite well. We do not see the same disparities in valuations as we did during the dotcom period. The dotcom bubble was localized in technology and communication companies, and during that period one could buy tobacco company stocks with double-digit dividend yields and industrial companies at single-digit earnings multiples (i.e., really, really cheap). Not today. The low interest rate environment and the central bank blackhole have brought almost every asset category to historically high valuations.

We sometimes hear that low interest rates drive a lower risk premium and therefore a higher normalized valuation level. But this has only been true over the past 40 years, in the presence of low inflation when rates were normalizing after the Volker period. If inflation persists and rates move higher, history suggests rather that valuations will drop, even for growth companies, a phenomenon the U.S. experienced in the 1970’s.

If inflation picks up, the graph below does not auger well for valuation levels. A negative relationship between P/E (price to earnings valuation) and inflation has existed for the last 100 years. The higher inflation is, the lower the valuation multiples are that the markets will pay for equities.

The question comes down to the path investors take to get to those lower valuations. In some cases, it is through companies growing their earnings into a more reasonable valuation. In others, it will be a resetting of prices to reflect a more modest growth in earnings. The latter is already showing itself in those companies that benefited from the pandemic as some of the benefactors have seen drops of 50-80% from their highs. No matter which, history suggests that the path taken will not be without volatility.

Conclusion

Though valuations can become anchored, making any normalization to historical averages take time, we suspect we will see periods that resemble the shorter corrections (i.e., one- to three-quarter long corrections, not multi-year ones) we have experienced over the past 10 years. Our suspicion lies in the complacency within the investment markets. This complacency has led to high leverage as many believe that central banks will defend assets prices rather than follow their overarching mandate to protect price stability.

If that is not the case and central banks prioritize price stability above all else, it will put significant pressure on those that have leveraged bets to the contrary with the result being margin calls. Correlations of all assets drive towards one when margin is called, fear takes hold, and people run for the exits.

We sit with a 20% allocation to cash across our strategies, expecting better opportunities to move back into a fully invested position.

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What changed?

The market has been on an upswing that has lasted longer than any time period in history without a 5% correction. 422 days when the average is typically about 200 days. The actual reason for the swift move over the past week is hard to pin down. However, quick adjustment in interest rates (from ~2.5% to 2.8%) combined with readings of a pick up in inflation (though still at very modest levels) were part of the equation. These generated a fear that the Federal Reserve Bank would need to accelerate the pace of rate increases, potentially increasing the chances of an economic slowdown.

Should we do something?

On Monday, January 29^th, Auour’s short-term signals became cautious as the rapid increase in the markets combined with the increase in interest rates caused us to believe the likelihood of a near-term soft spot had increased. We removed all leverage from our most aggressive equity product and increased cash to approximately 10% in all equity products. We also dramatically cut the equity weight in our balanced strategies with Global Balanced moving to 45% equity from 60% and our Multi-Asset Income strategy moving to 25% equity from 40%. Our Global Fixed Income also mitigated some risk by reducing exposure to the higher risk corporate and emerging markets as well as raising some tactical cash.

What caused the rapid deterioration over the past few days?

As we are only one participant in a market driven by tens of millions people, it is impossible to directly lay blame. Let us also remind ourselves that as of this writing, the S&P 500 has only retracted to levels last seen only two months ago. However, certain factors are reminding us of the speed (not the severity) of the very quick correction that occurred in 1987 caused by the broad adoption of portfolio insurance. In the 1980’s, large pensions were told that they could insure against market corrections through the use of derivative instruments. It became a self-fulfilling event which instigated a “run for the exits”, not driven by underlying company fundamentals.

Over the past year, it has become commonplace to see inexperienced investors bet against a rise in market volatility. This caused complacency to build and as we know, the market does what is most inconvenient for the majority of participants. The rapid rise in interest rates, the start of a market downturn, and the fear of government instability resulted in a rise in volatility. The rise in volatility created a panic among those betting against it and resulted in them covering their increasing losses. The absorption of that change in direction has resulted in a massive movement in the derivative markets, pushing markets down. Another case of a “run for the exits” that has little to do with underlying valuation or company fundamentals.

What do we do now?

Again, as only one participant in a field of millions, no one can accurately predict the short-term gyrations of the market. The volatility seen even within the last hour of writing this makes it difficult to gauge the value of short-term actions. Days like yesterday will take over emotions and blind you to logic. In 1987, the market dropped over 22% in one day yet if one looked at just the yearly numbers, the market was up over 5% for the entire year. Swings in markets driven by derivatives can produce wild daily and weekly rides but the fundamentals of the underlying markets are what dictate the long term.

We continue to evaluate the data and the global markets’ reactions to it. At this point, we do not see this as a systemic issue that could drive a deep and enduring downturn. Fundamentals around the world are very good. Interest movements to date are normal and well within our thinking of where they should be moving to. Events like the last week can and should raise fears. Yet, we take some comfort that our signals moved us into a more conservative allocation with tactical cash protection before this drop. Time and data will drive our decisions, not emotions.