A season of volatility in the equity markets has now stretched for several months. As of this morning’s open, the three major indices (DJIA, S&P500, and Nasdaq) are all beneath where they were 12 months ago. Many large Growth stocks in the Technology sector have dipped to 2020 pre-pandemic levels. Wild daily swings in both directions are happening and the days of little volatility are few and far between.
We thought it might be useful to readdress the causes of this volatility, talk about our current strategies, and discuss our plan forward.
The root cause is inflation, and the Federal Reserve’s efforts to stem the tide. As you are well aware, price inflation is caused when Demand exceeds Supply.
During the pandemic, both sides of the equation led to a harsh uptick in inflation. With workers staying at home and companies shutting down production, supply chains became severely constrained. The problem has persisted. On top of this came sharp increase in the money supply, which was the result of aggressive stimulus in the early stages of the crisis. The following chart of money supply illustrates the “dry powder” that is looking for home.
A lot of this money wants to be unleashed now that the world is emerging from the pandemic, and demand is extremely high. Intense Demand + Constrained Supply = Harsh Inflation, the likes of which we haven’t seen in several decades.
The Fed is trying to slow down the Demand by raising the Federal Funds Rate incrementally, put a halt to its bond-buying (i.e., stop feeding the money supply), while at the same time reducing its balance sheet (i.e., reclaiming a portion of the money supply). They want to make borrowing more expensive in an attempt to cool a Demand quotient that has been running hot. This three front approach to fighting inflation will undoubtedly succeed but the question is will it put the overall economy into recession.
Whenever interest rates increase, the value of bonds goes down. While the downward pressure is no where near as significant as it is on stocks, bonds are currently losing value but the higher interest rates will eventually mean more interest being paid on the bonds. In anticipation of rising interest rates, we shortened duration on our bond portfolio last year. Currently the average effective duration in our bond portfolio is 2.23. This is down from 3.97 as of the end of 2021. We have made some adjustments to the bond portfolio to reduce duration and the managers of the bond funds have also reduced duration. The shorter duration helps reduce the losses in bonds as interest rates go back up. Once rates stop increasing and level off, we will increase duration and begin receiving better yields.
The stock market is attempting the digest what all of this means for current valuations. Borrowing costs for publicly traded companies are increasing. Interest expense is going up, which will eat into profits (at least in the short term). At the same time, the market is attempting to gauge what a cooling of Demand means for these companies… and speculating on whether increased pricing will enhance or damage their cash flow. The valuations on companies that are not profitable and not cashflow positive are getting crushed. This is particularly evident in the high tech, growth, sector.
What are our current strategies?
For the short term, our Investment Committee continues to evaluate our allocations and make appropriate changes. Recently we have tilted our equity portfolio more towards Value versus overweight in Growth, which has helped. We are striving to remain balanced in Large Cap, Mid Cap, and Small Cap to stay as diversified as possible. We are also monitoring our Fund Managers and evaluating their outlooks against one another. We may be taking a bigger position in value and that shift would move the portfolio to slightly overweight value. Value should perform better during inflation and recessionary times.
As mentioned previously, we have shortened duration on the bond portfolio and will continue to keep durations short as interest rates increase. We will lengthen duration as rate increases level off.
One of the Funds we are closely monitoring is our Morgan Stanley Insight Fund, which has suffered due to its overweight in Growth Technology. Though the fund has taken a hit the past 18 months, it remains in the top of its peer group over a 5-year period. In conversations with the manager, and while we realize these positions are the most volatile in seasons like this, we believe these positions have great long-term upside. However, we continue to monitor this ever-changing landscape and will adjust accordingly.
Finally, we like alternative positions. For particular investors, a position related to multi-family real estate, where rent-increases are available in an inflationary environment, where generating income is key, and where demand should stay strong during a cooling housing market, makes for a potentially stabilizing addition.
For the long-term, history tells us that equities eventually do well following periods of inflation. As has been the case in every correction for decades, a market recovery is highly likely. Furthermore, the past several dips have resulted in a dramatic V-shaped recovery. As investors in equities, we expect seasons of volatility. The most successful investors are those that avoid making short-term decisions based on dire headlines and maintain a sound philosophy during these turbulent seasons.