2022 Review and Outlook – The Federal Reserve vs. Inflation

Portfolio performance in 2021 ended on a solid note with a strong December after a weak November. Most portfolios were up double digits for the year. This performance extended a winning streak that began at the end of 2018, despite the extreme COVID selloff in 2020. And, looking further back, portfolios have consistently gained since the Great Financial Crisis in 2008. Will it continue? Of course, this is the question everyone is asking. In this WJNotes, we review 2021 performance, discuss our 2022 outlook while reflecting on our 2021 outlook, and discuss portfolio positioning. For further insight into our views, please join us, either in-person or remotely, at our upcoming client luncheon in February.

Although not unprecedented, the performance of US Large stocks over the last three years has been stellar, up 26.0% compounded annually and up 26.3% last year. US Small stocks also did well for the year, up 14.5%. However, outside the US, the picture wasn’t as rosy. International developed stocks were up 11.7%, while COVID and China’s market manipulations led International emerging markets stocks to a -0.6% loss for the year.

Bond returns were weak in 2021, as expected. Historically low yields combined with increasing interest rates led to a loss of -0.8% for the bond benchmark we track. Some bonds did better: Treasury inflation protected securities (TIPS) were up 5.5%, and high yield/low credit quality bonds increased 4.3%. Long maturity bonds suffered. For example, long-term Treasuries fell -4.8%. The dispersion in bond returns is typical of a low interest rate environment and will make bond positioning critical in 2022.

Portfolio alternatives had a mixed year. Tactical strategies, which allocate between stocks and bonds, had a good year up 10.3% as they emphasized stocks over bonds. Trend following strategies also advanced last year as increasing commodity prices and rising bond yields led to persistent trends for most of the year. As a result, they were up 5.2%. Reinsurance struggled last year vs. a solid return in 2020 year as Ice storm URI, Hurricane Ida, and the awful Kentucky tornado dragged down performance leading to a loss of -4.8%.

Although the standard market indices like the Dow and the NASDAQ advanced last year, some market sectors struggled. Last year in our WJNotes Outlook, we discussed some market sectors that looked frothy and bubbly, like emerging technology, healthcare, and green energy. Most of these types of companies lose money, and some don’t even have sales. Cryptocurrencies fall into this bucket with almost no use except for speculation. Last year, we wondered whether a decline in these market areas would drag down the entire market. So far, the answer is no. Many of these stocks and cryptocurrencies are down 50 to 80%, while broad market indices are near all-time highs.

Rather than discuss individual names, we focus on an exchange-traded fund that is the poster child for hot, bubbly technology/ healthcare stocks. The fund is named the ARK Innovation ETF (ARKK) and is managed by Cathie Wood. In 2020, the financial press crowned her the new queen of Wall Street because of her supposed stock-picking acumen. Her performance through the end of 2020 was astounding, up 45.9% per year the previous five years. 2021 was not so kind to Ms. Wood. Her ARKK fund was down 23.6% for the year and was off 38.2% from its peak in February. The following chart shows historical performance for the last six years through the end of 2021:

The fund continues to struggle in 2022, down -15.2%, and is now about -50% off its all-time high. Is this result surprising? We don’t think it should be. Very aggressive strategies like those employed in Ms. Wood’s ARKK ETF take huge risks by buying unproven stocks with strong recent performance. Unfortunately, when the music stops and investors turn back to fundamentals, these stocks collapse. Will the market continue to hold up while these frothy areas come back to earth? We will likely find out this year.

The following chart demonstrates another lesson from Ms. Wood’s results and many other temporarily “hot” managers who have come before her.

The orange line shows flows into the fund, while the blue line shows the “investor return,” basically, the average return of all investors in the fund. As you can see, the blue line is now negative, meaning that investors, in aggregate, have lost over $1.8 billion despite a 31.0% per year return over the last six years. As always seems to happen, investors piled in chasing recent strong returns at precisely the wrong moment.

One more point to consider, exceptional performance usually comes from taking excessive risk, good luck, or a bull market. None should be confused with investing skill. The following popular meme portrays the latter quite well:

2022 Outlook – Inflation

Inflation is top of mind for most investors. The following chart shows US inflation over time:

The current inflation rate of 6.81% is the highest in several decades. Economists give a myriad of reasons for high inflation. Ultimately, no one knows what combination causes inflation, so we are left to speculate. The explanation that makes the most sense to us is relatively simple. Enormous Government spending has increased demand, and COVID has constrained supply. The combination not surprisingly, has caused prices to rise.

On the demand side, the following chart tells the best story:

The chart shows the purchase of goods in the US. Look at the dramatic increase in demand post COVID. Consumer expenditure increases have been relatively consistent historically except for the last two years. Why? The Government borrowed and spent/distributed over $6 trillion. And, in addition, the money mostly went to goods, not services, as we were stuck in our houses.

On the supply side, we think the following quote from Miguel Patricio, the CEO of Kraft Heinz in Time Magazine, best describes supply issues:

“It’s not that we don’t have ketchup. We have ketchup, but in different packages. The strain on demand started when people stopped going to restaurants and they were ordering takeout and home delivery. There would be a lot of packets in the takeout orders. So we have bottles; we don’t have enough pouches. There were pouches being sold on eBay.”

We believe a combination of inadequate supply, goods in the wrong places, and goods available in the wrong form have and will continue to constrain supply.

Increased demand and decreased supply always cause increasing prices as markets adjust to match supply and demand. Thus, it is no surprise prices have risen, and it will not be surprising if higher prices persist, although the rate of change will likely decline over time.

The other primary argument we hear for inflation is what we’ll call “money printing.” The Federal Reserve has expanded its balance sheet by over $5 trillion since COVID, and the expansion continues into 2022. The argument goes that the Fed’s money printing increases their balance sheet and causes prices to rise. The corollary to this argument is that bond yields will inevitably rise because investors will demand higher yields to protect against future inflation. We disagree that inflation is related to money printing for multiple reasons as follows:

1. Printing money/dollars should depreciate the currency. The dollar should be declining against other currencies. Inconveniently, it is not.
2. If investors were concerned that their bond holdings would be paid back in depreciated currency, wouldn’t they require higher and higher yields to protect themselves? Or thinking about it another way, wouldn’t they resist buying bonds at current yields? Either should result in bond yields rising. Although bond yields have increased, they’ve not gone up near as much as you might expect under this scenario. In fact, governments worldwide can’t sell bonds fast enough to satisfy demand. In Europe, bond buyers are so desperate to purchase bonds they pay for the privilege through negative yields. Strange behavior indeed if inflation was becoming a persistent problem.
3. Inflation estimates using market-based yields show inflation returning to around 2% over the next couple of years. So, either market participants in the aggregate are wrong (which is rare), or inflation will not be an issue in the future.
4. Money printing through quantitative easing is not a new phenomenon. Japan has printed money and bought assets for decades with no increase in inflation. Europe and the US began printing money through quantitative easing in 2009 with no inflation until recently. We just don’t see evidence of “money printing” leading to inflation.
5. Finally, and this is a bit in the weeds, quantitative easing or printing money to buy bonds does not actually create dollars. It creates bank reserves. Bank reserves are not inflationary unless banks lend them out. If they don’t, they sit on the bank’s balance sheet and do nothing. Real money printing, which would mean printing money and buying stuff with it or sending it to us, would be highly inflationary ala Weimer Republic or Zimbabwe. So far, this has not happened.

We don’t want to dismiss the potentially harmful effects of excessive Government Debt. Governments have historically extricated themselves from excessive debt by depreciating their currency (inflation). The US has not crossed this line yet.

To conclude, we believe a dramatic increase in demand from shifting consumer preferences, enormous Government spending and supply decreasing because of supply chain issues have caused inflation. It is not money printing or, at least as of now, Government debt levels. And, since COVID caused it, we believe it will dissipate. “Transitory” is now a bad word but is an appropriate adjective to describe current inflation.

2022 Outlook – The Federal Reserve (FED)

In June 2020, Jerome Powell, the FED chairman, gave a press conference and stated. “We’re not even thinking about thinking about raising rates.” Fast forward to today, and we are now facing an accelerated taper of bond purchases (buying fewer bonds) and likely three, if not more, rate increases in 2022. What has changed? The obvious answer is inflation. A more cynical observer might point to Powell’s desire to be reappointed as Fed chairman as the reason for his sudden focus on inflation. But, the FED, of course, is apolitical. Regardless of the reason, we are shifting from extraordinary Fed accommodation to less accommodative policy.

Is the shift in Fed policy necessary? If you believe, as we do, that inflation is the result of COVID, Government fiscal spending, and supply chain issues rather than an overheating economy or monetary debasement, a tightening of monetary policy is probably not the best response. Time will generally solve the problem as the impact of fiscal stimulus ebbs and supply chain constraints evaporate. Raising rates will hurt economic growth unequivocally and may not address inflation, leading to “stagflation.”

On the other hand, the Fed implemented current monetary policy in response to COVID and described it as an “emergency” response. We are no longer in an emergency, so tightening monetary policy seems sensible.

Also, whether tightening policy addresses inflation issues or not, it signals that the Fed is concerned about inflation and is doing something about it. Signaling is vital because inflation can be self-fulfilling. For example, suppose you believe prices are going up in the future. In that case, you buy now rather than waiting, which increases prices, causing more inflation. To break this cycle, the Fed needs to signal its commitment to fight inflation. They are sending this signal as we start 2022.

Since the Great Recession in 2008, the FED has supported stock markets through policy changes, interest rate cuts and direct bond purchases. Outright stock purchases haven’t occurred, but we wouldn’t rule them out in the future. For example, in 2018 when the Fed and Jerome Powell insisted on raising rates to normalize policy, the stock market sold off over 20% at the end of the year. Powell capitulated and ended rate increases. He caved to market volatility, and the market immediately recovered. The FED supported the stock market by changing policy.

So what happens if the market sells off this year? The FED can’t cut rates or change policy because it would signal they are not serious about fighting inflation? It appears that Powell and the Fed have a very narrow path between signaling their desire to control inflation and supporting the stock market. If they err on the side of overtightening, they risk a recession or stagflation. If they ignore a stock market decline, investors might panic. Stocks would suffer in either scenario.

Outlook 2022 – Valuation

In our opinion, US large stocks are overvalued. Consider the following chart:

The chart by Dr. John Hussman plots his proprietary measure of valuation over time. The current level is the highest on record. We could show many other valuation measures that are also at record highs. Why does this matter? Because valuations tend to revert over time to their long-term average. Stock earnings can stay the same, but stocks can decline because investors decide to pay less for current earnings. And the amount they are willing to pay can vary dramatically, as the chart shows. A rapid decline in valuations caused a stock market decline of over 50% for US large stocks (S&P 500) when the tech bubble burst in 2000. To be clear, we are not predicting a market crash. We, nor anyone else, can predict short-term market movements. But we do know that a return to historical valuations would lead to lower returns. This observation has no value in positioning portfolios today but matters tremendously for long-term endeavors like retirement planning.

Of course, we don’t just buy US stocks. About half of our stock portfolio is outside the US. Fortunately, non-US stocks are cheaper and offer better long-term returns.

Portfolio Positioning

Reflecting concerns about Federal Reserve tightening described above, we are slightly reducing our stock allocation in portfolios. The proceeds will go into shorter-term bonds and trend following alternatives. We would also describe the trades as rebalancing or selling the best-performing asset classes and buying underperforming ones. Rebalancing is a core component of our investment strategy.

We will be adding two new funds to portfolios in January. The first fund is Standpoint Multi-Asset Fund (BLNDX). The fund employs a dual strategy: buying 100% exposure to trend following and 50% exposure to global stocks through leverage. We’ve discussed leverage and its appropriate uses extensively in our recent luncheon and writings.

The second fund, named Avantis Emerging Market (AVEM) will be replacing Causeway Emerging Markets (CEMIX). CEMIX has been a reasonable performer since we bought it in 2016, but the new fund has a lower expense ratio (0.33% vs. 1.10%) and greater tax efficiency.

Capital gains distributions were substantial last year. As a result, portfolio cash balances are high as we entered 2022. We will be and have been investing the cash in January. Keep in mind that mutual funds and exchange-traded funds must pay out all their capital gains each year. Ideally, you would prefer to pay capital gains when you sell a fund, but the regulatory requirements mean you are prepaying capital gains without selling the fund. Note that capital gains distributions will result in additional taxes this year so please be prepared. We can help you estimate gains if you are interested.

To summarize, we will focus on the following strategies/themes in 2022.

• Continue to identify bond replacements to protect portfolios against stock market declines and provide returns above inflation.
• Prudently add exposure to credit through the bond market when opportunities arise.
• Incorporate reasonable portfolio leverage to maximize capital efficiency.
• Identify strategies that provide outsized protection on the downside.
• Ensure we are not overexposed to areas of the stock market that still appear frothy and bubbly, like Ms. Wood’s fund. And avoid fads like cryptocurrencies.
• Maintain exposure to market sectors like energy and financials that will benefit as investors move from growth to value.
• Keep costs low and minimize taxes.

We hope this gives some insight into our thinking and portfolio positioning. As always, we are trying to plan for the flood before it rains. We appreciate your support and are available to discuss your financial plan and portfolio at any time.