The Risk of Remaining Bullish and Your "Real Rate of Return"

& Other Economic News for the Week Ending 1-14-2022

U.S. Treasury bond yields increased across the yield curve last week, led by yields on the 2-year and 3-year Treasury notes. The 2-year treasury yield increased for the fourth straight week and nearly hit a two-year high last week as investors adjust to a tighter Federal Reserve outlook

On Wednesday, CPI data was released indicating that consumer prices rose half a percent in December, 0.1% above the consensus estimate. However, the big news was the cost of living, which increased 7% in 2021. This is the highest number in nearly 40-years. The inflation in December was broad-based, impacting all industries to some degree. The week wrapped up with retail sales data indicating a decline in December of 1.9%, well below the expected decline of 0.1%.  As we have stated in previous newsletters this large decline is largely attributed to the pull forward in holiday shopping driven by the fear of shortages by consumers.

Last week also brought Fed chair Powell's testimony to the senate committee. Powell said the central bank was ready for tighter monetary policy, but more importantly he stated that the economy was still strong, but as we look at the data, we see a different situation. For instance, jobless claims ticked up to 230K as employers deal with absent workers caused by the omicron variant. U.S. retail sales fell sharply in December, down 1.9% and 2.3% excluding autos as surging prices weighed heavily on consumers. 

The Risk of remaining Bullish

Over the last few years in particular, as valuations have become more extreme, the consistently bullish media continue to invent rationales for higher stock prices. Low interest rates justify high valuations.

There is no alternative (T.I.N.A.) (fixed Income doesn’t generate any yield

Monetary policy supports higher prices, Low inflation supports higher prices

Those rationalizations appeared correct due to the massive flood of monetary and fiscal policy over the last few years, especially fiscal policy during the pandemic.

There are too many variables that can occur that could change outcomes for the better or worse

However, as we head into 2022, here is a shortlist of the things we are concerned about and are preparing to hedge portfolios against should the economy derail.

• Economic growth will slow as year-over-year comparisons become far more challenging.
• Inflationary narrative remain persistent pressuring the Fed to raise more than necessary hence             impacting consumption and compressing profit margins.
• Corporate earnings disappoint based on miscalculation of growth expectations.
• Valuations begin to weigh on investor confidence.
• Corporate profits weaken due to slower economic growth, reduced monetary interventions.
• Consumer confidence continues to weaken as consumption is crimped by rising costs and             slowing economic growth.
• Interest rates rise which trips up heavily leveraged consumers and corporations.
• A credit-related event causes a market liquidity crunch.
• The Fed makes a “policy error” We think this is highly probable
• The “housing bubble 2.0” implodes. So is this one
• Corporate stock buybacks, which accounted for 40% of the market’s appreciation since 2011, slows as companies begin to hoard cash as the economy slows
• The massive inflows into US equity markets turn to outflows as retirees hold on to cash.

While analysts on Wall Street are confident the bull market will continue uninterrupted into 2022, there are more than enough risks to derail that market outlook. In addition, a negative prediction would not go over well with investors and halt inflows of dollars, which impact their compensation.  So, we feel there is a bias in their prediction. However, what you should be concerned about is the protection of your gains from the last few years so keeping the same strategy may end poorly if you do not have someone that pays attention to your assets. 

Understanding the real rate of return

So, you think you had a great year in 2021? If you’re not familiar with your real rate of return you may want to better understand how this is impacting some of your portfolio decisions. The real rate of return on an investment takes inflation into account when calculating a return. So, for those who are older and are dependent on a yield from their investments, the following may concern you.

The real rate of return of an investment in a single year is calculated by subtracting the total return (Interest, dividends and appreciation) of the security by the rate of inflation. Inflation is something that we have ignored for the last decade, since inflation has been hovering around 2%. However, this past week the CPI for 2021 was released and wacked everyone over the head with a whopping 7% rise for the year ending 2021.   

Ok So what does this really mean? If we look at the close on 12/31/21, the yield on the benchmark 10-year T-note was 1.51% (1.5% rounded), The trailing 12-month rate on the CPI came in at 7.0% for December 2021. That equates to a real rate of negative -5.5%. Not only is this not attractive it’s a significant loss to anyone with a portfolio mixed of 40-60% of fixed income securities.

Historically Bonds were considered conservative investments. If you have taken on of those 7 questions risk tolerance questionnaires and generated a score of risk adverse, you would have been placed in more fixed income securities.  At a base level, in order to maintain one's purchasing power, bond investors have always sought to generate a yield that at least outpaced the rate of inflation.

For comparative purposes, from 12/31/91 through 12/31/21 (30 years), the average yield on the 10-year T-note was 4.03% (4.0% rounded), while the average rate on the CPI stood at 2.3% over the same period, (this according to Bloomberg). Those figures translate into an average real rate of return of 1.7%, far more attractive than currently available. These would be considered normalized yields/rates, in our opinion.

Federal Reserve (“Fed”) Chairman Jerome Powell has changed his expectations on inflation from characterizing it as transitory to it being more persistent in nature. (We disagree with him and think it will level out my end of Q2 or Q3)

The recent Fed announcement that it will reduce its purchases of Treasuries and mortgage-backed securities by $30 billion per month, will reduce M2 money supply, one of the functions of inflation, but at that pace, it should be done buying bonds in the open market by the end of March 2022. It also foresees hiking short-term interest rates three times in 2022. Currently the federal funds target rate (upper bound) is currently at 0.25%. Its 30-year average is 2.52% (2.5% rounded).

As we have stated in the past the challenge for the Fed, raising rates in a slowing economy seldom results in a smooth landing.

Is your portfolio vulnerable

One of the problems with the financial markets currently is the illusion of performance. That illusion gets created by the largest market capitalization-weighted stocks. (Market capitalization is calculated by taking the price of a company multiplied by its number of shares outstanding.)

Except for the Dow Jones Industrial Average, the major market indexes are weighted by market capitalization. Therefore, as a company’s stock price appreciates, it becomes a more significant index constituent. This means that prices change in the largest stocks have an outsized influence on the index.

Basically, passive ETFs & Index Funds are creating this issue and concealing a bear market in stocks. That may sound like a strange statement when you look at major stock market indexes hovering near all-time highs. However, much like an iceberg, what we see on the surface hides much of what lies beneath.

So here is how it works Index Funds and ETF’s are considered passive investments meaning that when money is deposited into the fund is gets fully invested and allocated disproportionately. More dollars are directed to larger market cap stocks. But as discussed in a previous newsletter its not really passive (meaning buy and hold) it’s a buy and buy momentum strategy.

Currently, the top-10 stocks in the S&P 500 index comprise more than 33% of the entire index. In other words, a 1% gain in the top-10 stocks is the same as a 1% gain in the bottom 90%.

One of the best representations of the disparity between what you see “above” and “below” the surface is the ARKK Innovation Fund (ARKK). While the S&P 500 index was up roughly 27% in 2021, ARKK was down more than 20%. That is a 47% difference, quite a performance differential but shows the disparity between the mega-cap companies and everyone else.

Eventually, some unexpected event will change investors’ “speculative” psychology. When the psychology changes from “bullish” to “bearish,” the rush to liquidate entire baskets of stocks will accelerate the decline making sell-offs more violent than what we saw in the past.

This concentration of risk, lack of liquidity, and a market increasingly driven by “robot trading algorithms,” reversals are no longer a slow and methodical process but rather a stampede with little regard to price, valuation, or fundamental measures as the exit becomes a rush to get out first.

Its all in your perspective

In last week’s senate hearing The Fed’s Chair Powell said the economy is strong and stated that there would be several rate hikes beginning in March of this year in auditioning to expediting the Feds tapering of Bond buybacks. 

However, the data (and the Fed’s own Beige Book) say otherwise. But when the Fed becomes politicized it bends to the needs of the Administration instead of the overall economy. 

So let’s be clear on a few things, the inflation we are seeing now is due in part to supply chain issues and the Fed’s tools are inappropriate to fight inflation induced by these shortages.  The second component is Housing “rent”, which is a self-inflicted wound caused by too many people not paying their rent and spending the helicopter money of discretionary items.  Landlords have had no choice but to increase rents to make back the monies lost during the pandemic’s

The ultimate consequences of the Fed’s actions could possibly lead to a continuation of today’s high inflation levels. It’s a tricky situation and the tailwinds that have propelled the economy (and caused the inflation) are gone:

The three rounds of “Helicopter Money” from the IRS ended last spring;

For those states that opted-in, Supplemental $300/week Unemployment Benefits ended in September;

The expanded child tax credits (for 2021 only) ended in December; no longer will families be receiving $300+/month for each child in their household under 18 years of age;

Eviction moratoriums and rent deferrals have ended, meaning rent payments (and likely some back rent) must now be made out of current income which will no longer be available for consumption as it was in 2021

While student loan payments continue to be deferred (until April 30), unless extended again, payments will soon be required; hence removing cash from the consumption stream;

Market interest rates have risen in anticipation of pre-announced Fed rate hikes. As a result, mortgage interest rates are rising. This will negatively impact mortgage applications which will slow the housing market and reduce growth (the “good” effect here is that home prices may stop rising).

When the December employment surveys were taken (week of December 12-18), omicron wasn’t a big factor. Even so, December’s employment report was much weaker than expected. Omicron is sure to have a negative impact on the January employment surveys taken this past week (January 9-15). We have already seen large spikes in the Initial Unemployment Claims (ICs), shown on the right-hand side of the chart. There are also spikes in the Continuing Claims data.

Normal: Do you even know what that means anymore? When the pandemic began, no one expected it to last as long as it has. Besides the original Covid-19, we have had renewed spikes from both the delta and omicron variants. Both of these have impacted the labor force, preventing the Labor Force Participation Rate from returning to its pre-pandemic level, and now causing rampant labor absenteeism. Is omicron the last variant? If not, the economic disruptions we are currently experiencing will continue, as will the inflation that results from supply and labor issues. Perhaps this will be a good thing if you’re in the media business and can make a hefty profit on scaring people. But the big change is women in the workforce and if they will return full time or find some hybrid way to parent and work.



The Week Ahead

U.S. markets were closed yesterday in observance of MLK Day, so it’s a short week and the rest of the week offers a bit of a respite from the recent data deluge. Fourth-quarter earnings reports will begin to garner more attention, with many financial companies releasing results this week.  Housing reports dominate the U.S. economic calendar, starting with the NAHB Housing Index on Tuesday, followed by housing starts on Wednesday and existing sales on Thursday.

Mortgage rates have reached their highest level since March 2020. Two key regional manufacturing indexes will drop: New York on Tuesday and Philadelphia two days later. Internationally, no policy changes are expected from the Bank of Japan tonight. China announces GDP, retail sales and industrial production early this week, with results expected to reveal a slowing economy. Other events of note include CPI and retail sales from the UK and Canada, economic sentiment from Germany and the Eurozone, and employment updates from Australia

This article is provided by Gene Witt of  FourStar Wealth Advisors, LLC (“FourStar” or the “Firm”) for general informational purposes only. This information is not considered to be an offer to buy or sell any securities or investments. Investing involves the risk of loss and investors should be prepared to bear potential losses. Investments should only be made after thorough review with your investment advisor, considering all factors including personal goals, needs and risk tolerance. FourStar is a SEC registered investment adviser that maintains a principal place of business in the State of Illinois. The Firm may only transact business in those states in which it is notice filed or qualifies for a corresponding exemption from such requirements. For information about FourStar’s registration status and business operations, please consult the Firm’s Form ADV disclosure documents, the most recent versions of which are available on the SEC’s Investment Adviser Public Disclosure website at www.adviserinfo.sec.gov/