There is a natural order to the world around us, and to the financial markets as it turns out. In both cases, if you mess with it too much, you can get a lot of bad results. Thus, we find ourselves in the middle of what many are calling the ‘Great Unwind.’
It comes as no surprise to our readers that we believe the U.S. Federal Reserve has overstayed its welcome in the markets, particularly with interest rates. When you tamp down and artificially keep interest rates too low, yes, you stimulate the economy. However, you cause unintended consequences that become the new problems for you to solve. The big one we are speaking with clients about lately is inflation. Recall back in April of 2020 how we speculated that all of the free money printed out of thin air would set the stage for a 1970s-style inflation scenario. Sadly, this has proven correct.
The Great Unwind is now the new problem – a self-inflicted wound upon which the history books will have the final say. The Fed added more than $8 trillion dollars into the economy from the time the COVID crisis hit until now, so when you see the whipsaw volatility of the markets trying to figure out the road ahead, it’s no wonder risk is coming off. In other words, when uncertainty is high, the markets will move lower. This is a universal truth about how capital markets work.
Inflation in-and-of itself is not an automatic bad thing. In fact, it is deflation that is the real bad guy in markets and the economy. When inflation is raging – like now – the answer is easy. You raise interest rates to cool things off and bring prices down and you can keep raising until you get the desired effect. In the world of deflation, you can technically only lower interest rates to zero in order to stimulate the economy. This is not entirely true, however, as Europe took interest rates negative for a time in the recent past.
So where are we today? Too much free money in the system ballooned up prices on everything from used cars, to houses, to the stock and bond markets. Now we find ourselves in reverse from more than a dozen years of the Fed pumping the economy. The question anymore isn’t, “Will prices fall?” it’s, “How far will they fall?” Clearly, a lot of selling has been done in the stock market with the NASDAQ down ~30%, the S&P off more than -20% year-to-date. The bond market is supposed to be the place to go for safety, yet with interest rates on the march higher, is also down double digits in 2022 (bonds also posted a measurable loss in 2021 being down more than -7%). In essence, the Fed has taken away this very important part of portfolio construction by artificially keeping interest rates way lower than their natural state. Now we are paying the price. Fortunately, we have ways to combat this problem and not only keep from losing, but actual profit from these down markets.
One of the ways we have beaten this relentless downward trend in the markets is by using the Alternatives – funds and strategies that ideally have little-to-no connection to the movements of the stock or bond markets. We refer to this in investment-speak as “low correlation.” When you can mix into a traditional portfolio several strategies that can go up in value even when the stocks and bonds aren’t (like today), you end up getting a really smooth return from your investments. Since the COVID crisis of 2020, we have seen the Alternatives that we use really catch a tailwind and post surprisingly strong, positive results. To say we are pleased with this outcome would be a big understatement.
Finally, one of the interesting twists to the markets this year is that we have seen several times where the mostly negative news flow has not translated into lower prices. This happens with investors go to an extreme in either how confident they are, or how bearish they feel. It doesn’t happen often, and can cause many – even professionals – to sit back and scratch their heads in wonderment. Most recently, the indicators that we watch for signs of too much buying or selling are very strongly signaling that there has been too much selling, and a rebound of significance is close at hand. The set up we see across many areas that we watch are telling us that, despite the potential for things to get worse with inflation, the war in Ukraine, a possible recession, etc., a lot of selling has already been done and the risk/reward to holding or even adding to stocks is favorable. So, we find ourselves negative on the news, yet positive on the markets. This phenomenon may not come around for years, but when it does, history tells us that a bull market in bearishness can come to an end even when the world around us continues to look bad.