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Market Commentary

It Ain’t What You Don’t Know That Gets You Into Trouble…

Capital markets are really a microcosm of life in so many ways, with so many lessons learned in markets that apply to life. The title of this piece, historically credited to Mark Twain[1], is merely a setup for the more important second half: “It’s what you know for sure that just ain’t so.” As in life, market history is replete with instances of “certainties” that turn out to be truly anything but certain. When you think about it, this is the general nature of markets; market participants operate in an arena of imperfect information and, consequently, must continually assess the risk-reward dynamics given the likelihood of all possible scenarios.

At Balentine, we operate with this philosophy, routinely assessing our positioning with a quantitative assessment of the underlying environment and quantitative possibilities looking forward. As a result of this, our investment goals are aligned with those of our clients, namely delivering what we believe to be the best opportunities in an environment where perfection and certainty do not exist. Unfortunately, this contrasts with many pundits in the financial media, whose goal of looking omniscient does not allow for uncertainty in their comments or predictions. After all, what good is it to have such an “expert” on a show if all they can tell us is that they are unable to give us answers. As a result, all kinds of certainties are espoused with little regard for the possibilities that data may present otherwise.

It’s what you know for sure that just ain’t so.

Since June 16, we have witnessed the market follow the template for a bear market rally. The rally’s characteristics were as follows:

·       Two-month duration, peaking on August 16

·       Generated a price return of 17.4%

·       Retraced 56.7% of the decline from the January 4th peak.

Not one of these data points is outlandish by historical standards. Figure 1 confirms the historical precedence by comparing data from the current rally to data from the initial rally in each of the prior four bear markets,

Figure 1. The market rally from June 16-August 16 was very much in line with historical precedent from prior bear markets.

Source: FactSet and Balentine

Market narratives – Caveat Emptor!

In the financial media, pundits of all stripes have touted that the bottom is in — and happy days are here again[2]. In our view, such optimism within a context of uncertainty is in line with historical precedent. For example, when the Federal Reserve orchestrated the sale of the collapsing Bear Stearns to J.P. Morgan Chase in March 2008, it was believed that the worst of the crisis was over, restoring confidence in the financial system.  Could June 16 have been the market bottom of the current market downturn? This is a possibility – but unlike those espousing such certainty, we are loath to declare such a statement given so many uncertain variables interplaying in today’s environment. In other words, just as we are hesitant to state that the bottom is in, we are equally as averse to saying with certainty that the bottom is not in.

Let’s explore another example. Of late, the financial press has often asserted that when a market retraces 50% of its decline, it is a given that the trough was the ultimate trough and that a new bull market has ensued[3]. Again we see certainty declared in an environment of uncertainty — and ironically the basis of this certainty is historically inaccurate! (i.e., it’s what you know for sure that just ain’t so”).  Figure 2 shows several historical examples of retracements greater than 50% that did not indicate the ultimate bottom was in. Interestingly, these occurred fairly recently, yet for some reason this has escaped much of the investing populace.

Figure 2. History suggests the “certain” 50% retracement rule is flawed.

 

Source: FactSet and Balentine

Interestingly, we have yet to see comparisons to the 1970s or early 1980s; everything was 2000 and 2008, which represents yet another example of recency bias. We admit that some features of today’s market are similar to the bear markets in 2000 and 2008, as can be seen through our comparisons of the reaction during our current period to the reactions during those two periods. Far more importantly, however, we believe that, when considering today from a large-scale, global perspective, there is enough difference between these periods to render the comparison less effective. Also, the Federal Reserve played a different role in these periods. In 2000 and 2008, the Federal Reserve was an ally via dovish policy. In contrast, today the Federal Reserve is on the opposite sideline with hawkish policy, which may represent the most pivotal side switch since the 1920 Babe Ruth trade.

Hawkish monetary policy means volatility and selectivity

Markets often look for silver linings. The market is aware of the Federal Reserve’s hawkish stance and is consistently on guard for a change. The strongest portion of the rally from June 16 to August 16 was triggered on July 22, when the market took comments from Fed Chairman Powell to be a dovish pivot. Chairman Powell clarified himself in a hawkish direction on August 26, and the market has reacted accordingly ever since. This is the kind of volatility we expect in bear markets.

So, where does this leave us? Was the bottom on June 16 a resumption of the bull market and all-time highs in the next 12-18 months are fait accompli? Or, rather, are we now in a resumption of the bear market and when the S&P 500 bounced for two months beginning June 16, it was a temporary break from the bottom? Not surprisingly, in an environment of imperfect information, we cannot say for sure, of course. So, it is up to us to look at both possibilities and quantitively assess through our model process and through our discipline what the risk-reward dynamic suggests.

As we start our analysis and consider the appropriate investment allocation, we note that there are three options for the current state of the market. We mentioned above that we could be entering a bull or bear market – and there is a third option: we could muddle for years in a large range. Figure 3 illustrates the post-1974 bear market period as an example.

Figure 3. Recent history has accustomed us to V-shaped recoveries; a longer look at history suggests other possibilities.

Source: FactSet and Balentine

Bull markets typically begin when no one is expecting them, after conditions have been rough for quite some time and there has been economic pain (i.e., after all the bad news is out there and there are no more skeletons to uncover). While there is compelling evidence that economic momentum is weakening, and inflation remains “sticky” in many developed economies, we would be hard pressed to call the current conditions “rough.” That said, everyone knows inflation is bad, and with the likelihood that it seems to have peaked, it is well known to investors that the trip back down to low inflation will not be swift. It is typically the case that for bear markets to endure, a new catalyst needs to emerge – known unknowns will not accomplish the trick.

On the other hand, Jerome Powell’s remarks on Aug. 26 may have been the new information that the market needed for the bear to resume. Recently, the market is used to V-shaped recoveries — such as the ones we saw in 2018 and 2020 — so perhaps it has been conditioned to assume that even when the Fed takes a hawkish stance, they are really just jawboning and that a dovish posture will emerge. Historically, markets have not always had a V-shaped recovery – and Chairman Powell’s statements suggest that The Fed will not supply the liquidity to effect a V-shaped recovery. They need tighter monetary conditions to get inflation re-anchored and a V-shaped recovery in the equity markets would serve to loosen monetary conditions.

The reality is that Chairman Powell is well aware of the history of monetary policy errors under Arthur Burns and William Miller, mistakes that led to a reoccurrence of inflation in the mid-1970s after having been tamped down early in the decade, which he reaffirmed last week in saying, “The historical record cautions strongly against prematurely loosening policy.”[4] So, we think it is a mistake for the market to interpret a slowdown in rate hikes to +50bp or +25bp hikes as a full pivot. In the early 1980s, it took three years and two recessions to finally anchor inflation expectations, and it is possible the pain here may follow a similar path.

It appears to us that the two main macro drivers for equity prices over the last few months have been interest rates and the value of the U.S. dollar. Rates peaked two days before the market bottomed in June, and as they pulled back, equities rallied. Now that they have continued their ascent, equities have resumed their struggle; we find this unsurprising, as continued upward pressure in rates will be a headwind for equities. In contrast with rates, which experienced a decent pullback, the USD has pretty much been full steam ahead. We are seeing multi-decade lows in the euro, pound, and yen as the dollar throws off the albatross of domestic inflation and continues to surge higher. Similar to rates, this will continue to be a headwind to equities as long as this persists.

If the Fed says they are going to be tight, our discipline suggests it is wise not to fight it. Similar to how “Don’t fight the Fed” was the mantra on the way up, it’s the same refrain on the way down. Powell does not want a stop-and-go monetary policy. In fact, we would posit that given the stickiness of inflation in wages and rents, perhaps market participants should give more credence to the possibility that the Fed overtightens past the current consensus peak Fed Funds rate of 3.5%-4.0% than undertightens and pivots. Importantly, regardless of the terminal Fed Funds rate level, the item flying under the radar here is that we basically have not even begun to see the effect of the balance sheet runoff – that has barely gotten started, and that will accelerate starting in September. While valuation drives longer-term market returns, medium-term returns are more so a function of liquidity and sentiment, as we saw during the years of Quantitative Easing. Now that things are going in reverse from a monetary perspective, we see the smart move as moving to sidelines and letting the market tell us when all of this has played out rather than relying on some many “certainties” that may or may not come to pass.

Our model is suggesting the same approach. Stocks have become expensive relative to bonds at current yield levels, and our model process suggests that such a dynamic, when combined with deteriorated momentum, necessitates a move to the sideline to wait for better opportunities to assert themselves. This will allow much of the uncertainty during this time period to resolve itself, which may be especially important during a period where the macro picture is exhibiting characteristics that have not been seen for over 40 years, a period in which the vast majority of current investors have never invested and, thus, “what they know just ain’t so.”

[1] Mr. Twain is the subject of a lot of misquotes, so we cannot be absolutely certain that he coined the phrase.
[2] We are loath to call out specific “experts,” however a quick video search on the website of your preferred financial media source will come up with a plethora of instances of bottom calling.
[3] Again, a quick google search will pull up recent instances of this discussion.
[4] The Fed, Monetary Policy and Price Stability

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