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The Brave Report: Market Commentary for May 2022

Click here for .pdf version of this report:The Brave Report-May 2022

Patience, patience, patience… The markets have not been a fun place to be over the past month.  Inflation headwinds and uncertainty about the Fed continue to drag markets lower.  What started as selling in the high multiple stocks a few months ago has rolled over to even include the profitable places of the market and buyers have yet to step in and buy the dip.  In times of this kind of volatility, it is important to remain patient and refrain from making long-term investment decisions based on short-term volatility.  When the dust finally settles there will be opportunities, it is just a matter of dealing with the pain while we wait for those opportunities.

Market Overview

It was a very difficult month for all of the major averages.  The Dow only lost around 5% but the S&P 500 and NASDAQ lost 8.8% and 13% respectively.  This marked one of the worst months we have seen in years. It was the worst month for the S&P 500 since March 2020 and the worst month for the NASDAQ since October 2008. While the selling was more pronounced in the technology, consumer discretionary and communications services sectors, very few areas of the markets were spared.  Consumer staples was the only sector in the green for the month.

The fixed income side also saw some major movement over the past month with rates continuing to spike.  The yield on the 10-year Treasury moved rapidly from around 2.3% to just shy of 3%.  This continued to put downward pressure on bond prices across the board.  The core US Aggregate Bond Index lost almost 4% during the month. We have not seen this type of movement across the fixed income space in years.

The last month has undoubtedly been a difficult time for most investors.  As long-term investors, we understand that volatility is going to happen and that pullbacks are going to occur. These pullbacks are not only healthy for markets but can create the foundation for upward momentum.  The pullback we have seen to start the year and that accelerated over the last month has seemed a bit more painful than most.  This is due to a few factors.

First, with the bull market we have been in for the last decade, these types of pullbacks have been a bit rarer and in recent years the “the markets only go up,” mentality has brought new investors into the fold that aren’t used to corrections.

Second, the day-to-day volatility and the speed of some of the selling has been quite high. Multi-percentage point intraday swings have become the norm.  This makes it very difficult to enter and exit long-term positions, even on the margins.

Lastly, this pullback has left very few places to hide.  We have seen stocks sell off rapidly while bond prices have also plunged, muting many of the benefits of a diversified portfolio.  Additionally, with inflation so high, sitting in cash has also been a losing proposition.  Unless you are an experienced short-term trader, who is comfortable shorting the market, you have just had to take it on the chin and remember that long-term performance is what is important.

I understand that those are not encouraging words, but they are the reality of where the markets currently are, and I expect this kind of choppiness to continue throughout the rest of the year. Inflation is the big elephant in the room and until we get some more clarity around the various forces influencing it, the market is left to decide how high and for how long inflation will continue to rise.

The major factor that investors are trying to handicap is how aggressive the Fed will need to get to keep inflation under control and what damage this will do to the economy.  Will it just slow things a bit or will we experience a recession? Right now, the markets are pricing in around ten quarter-point rate hikes. This would bring rates up to just above where they were in late 2019 and in line with longer-term averages.  The difficult part in handicapping how aggressive the Fed will need to be is that there are several external forces that are impacting inflation and their outcomes are uncertain and often intertwined.

Going through the pandemic there have been numerous supply chain disruptions that put some initial pressure on inflation. The growth of the economy during this time also added to upward pressure on prices.  The thought by many, even those at the Fed, was that this upward pressure would be transitory and as we came out of the pandemic, these supply chain issues would lessen, and inflation would return to historic norms.  However, this did not happen to the extent we expected and then we were hit with two unexpected external shocks.

Just as it looked like we were getting COVID under control in the US and Europe and our economies were opening up, China started to experience widespread surges in cases.  Their “Zero COVID” policy pushed them to lock cities down and put widespread restrictions in place. This sent an additional shock through global supply chains and added additional upward pressure on inflation. They continue to struggle to administer an effective vaccine and until they can get things under control, this pressure will persist.

At around the same time as this, Russia began its invasion of Ukraine.  The fear of war was enough to rattle markets, but it also added upward pressure to inflation.  Energy and food prices surged, especially in Europe. While domestically we do not rely on that part of the world for food or other imports, the global food chain and energy supply is reliant on that region.

With all of this going on, there are also those who think that inflation is just a result of the post-pandemic recovery and the growth associated with it.  Their feeling continues to be that the forces impact inflation will self-correct and that while inflation wasn’t as transitory as initially thought, it will return to historic norms sooner rather than later.

So, what is the Fed to do?  They are trying to walk a tightrope between keeping inflation under control while not causing a recession. All of this, while Russia and China are shaking the tightrope.  That’s what makes the outcome so difficult handicap. When this happens the default setting for investors is to just move to the sidelines and that is what they have done over the past month.

As long-term investors, we are taught to use times of fear and uncertainty to our advantage.  We should use these corrections as opportunities to buy quality while it is on sale.  I think this is again one of those opportunities, but I would be very patient in doing so.  We are not in an all-in, buy the dip moment, but in a time when we should slowly add to positions when the opportunity presents itself.  There will be numerous opportunities to add to positions over the coming months so do not rush.

As we look out over the rest of the year, we will see continued choppiness and volatility as we sort through inflation data.  As I mentioned, ten rate hikes are currently priced into the markets.  I don’t think we will see all ten and if there is any indication that we won’t, then I think we can declare a bottom in this current pullback.  It will be very important to watch the situations in China and Russia.  Any positive developments in those situations will be one indication that the Fed may not have to get as aggressive as the markets currently think.  It will also be important to continue to watch key inflation data.  The markets have and will continue to react swiftly to any data that goes against expectations.  This has driven markets lower so far this year with inflation data coming in hotter than expected but the opposite can happen if we see a surprise in the other direction.

Strategy Commentary

I continue to stress patience when it comes to my portfolio allocation and new investments.  Of course, I wish I had raised more cash in March but with the speed and severity of the pullback over the past month, it is very hard to have great conviction in either direction.  When bonds and stocks become correlated to the downside, you are left to make no-win allocation decisions.  In these environments, it is important to revisit your timeframe and risk tolerance.  If your timeframe is shorter in nature, I would look to raise cash on any strength.  If it is longer, there will be an opportunity to put some cash to work over the next few months, but I am in no rush.

On the domestic side, there have been few sectors to hide in and I think that even within some sectors there are major winners and major losers. For example, I discussed earlier this year that within technology there are two types of stocks, story stocks and profitable stocks.  Even though some of the large tech names have rolled over in the past month, I will still be looking to add to these profitable companies as long-term plays. This upgrade in quality is not limited to technology but can be found across the board.  I still have refrained from chasing energy stocks as they have outperformed and am currently comfortable having a relatively sector-neutral allocation while looking to upgrade quality when the opportunity presents over the next few months.

The international markets have not been spared, especially with Europe’s reliance on Russia for oil and gas. I started adding a little to developed international positions at the beginning of the year but scaled this back when Russia invaded.  The Ukraine situation will be a continued drag on European economies for some time.  The same can be said for emerging markets so I am fine staying neutral

I continue to hold increased cash positions as a replacement for some of my fixed income allocation.  With both stock prices and bond prices dropping over the past month, the diversification benefits of fixed income have been muted.  With continued upward pressure on rates, I do not expect to add any fixed-income positions in the short term.  There will be a point where rates overshoot to the upside and we should be able to start adding back to fixed income at that point.