January 10, 2022

THE SECRET SITS

by Adam J. Morgan, CFA, CMT

Every year around this time, the investment management community feels compelled to offer forecasts, predictions, and outlooks for the coming year.  The problem is, collectively, we’re terrible at it. Nobody makes meteorologists look better…

If you’ve read financial news or watched any of the business-related entertainment networks recently, you’ve probably heard several predictions of an upcoming recession in 2023. In fact, if our economy does go into a recession, it will surely be the most predicted one of all-time. Typically, when so many display this much confidence around a forecast, it’s helpful to remain skeptical. I’m reminded of the poem “The Secret Sits” by Robert Frost, “We dance round in a ring and suppose, But the Secret sits in the middle and knows.” I’d love to see someone on CNBC inject that kind of honest uncertainty into their investment outlook, but I won’t hold my breath.

Developing a forecast of how economic conditions will evolve and how investment markets may behave is an important way to be best prepared for what might occur. I try very hard to estimate future market behavior using data and historical context, while avoiding subjective considerations and behavioral biases.  And it’s important to try to assign a confidence interval to every outlook as a way of acknowledging the appropriate degree of uncertainty.

The Federal Reserve offers their base-case economic forecast in a document called, “The Summary of Economic Projections.” In the most recent release made public on December 14th, they paint a picture that is now being referred to as “a soft landing.” According to the Fed’s median forecast, they believe that we will be able to avoid a recession in 2023 entirely. They believe that they will successfully bring inflation back down to their 2% target by continuing to raise interest rates on into 2023 and do so while real GDP grows for the year. Furthermore, they believe that they will be positioned to then lower the Fed Funds rate in 2024 even as the rate of inflation continues to drop, all without the unemployment rate rising above 4.6%. I’m skeptical.

For months the Fed and many others were saying that inflation would be “transitory” and dissipate on its own. That view was clearly naive.  They have now raised the Fed Funds rate 425 basis points (or 4.25%) in 2022 to modulate the rate of inflation. That is the most rate increases in any one year since 1980, and yet inflation remains an issue.

However, those rate increases have had an impact. The money supply, as measured by M2, has begun to come down, and price reductions can be seen at the gas pump, as well as the Case Shiller Home Price Index. But the notion that further monetary tightening measures can be taken whilst the economy continues to grow is a curious one, especially when you consider the Fed’s less than stellar track record at fighting inflation without creating a recession. In fact, according to a recent study by Harvard economist Larry Summers and Harvard research fellow Alex Domash, since 1955 there has never been a quarter with average inflation above 4 percent and unemployment below 5 percent that was not followed by a recession within the next two years.  Those conditions have been met.

Analysts who cover S&P 500 companies also appear to share the Fed’s optimistic outlook. Industry analysts are relied upon to estimate future earnings growth for the companies in their coverage space. According to FactSet, analysts estimated that all S&P 500 companies would earn $222.38 per share in aggregate for 2022. Today, that same forward-looking estimate for 2023 has only lowered marginally to $218.47 per share. So analysts’ 12-month estimate of corporate earnings for 2023 is only 1.7% lower than their expectation back when fed policy was extremely accommodative.  To put that number in context, according to research firm Strategas, during recessions earnings decline on average about 30 percent with a median of down 22 percent.

Those same industry analysts provide a year-end target price for each of the companies that they cover. According to FactSet, when you aggregate those estimates based on the company-level target prices submitted by analysts for all companies in the index, the estimated closing price of the S&P 500 at the end of 2023 is 4,493.50, or 15% higher from where the S&P 500 trades at the time that I am writing this on December 28th. Again, I’m skeptical.

In my opinion, the labor market is the most important aspect of the entire equation. The Fed needs to bring down inflation and they’ll need to increase the unemployment rate to accomplish that. The Fed has acknowledged that while recessions are bad, runaway inflation is worse. So in a sense, higher unemployment is bad news and good news. This is the corner into which the Fed has backed themselves. We have begun to see layoffs already and unfortunately, or fortunately, according to the St Louis Fed, delinquencies on credit card debt have already begun to creep higher. If you’re a millennial who has convinced yourself that working-from-home is the new way of life, you may want to re-consider that. Companies will be trimming the fat in the coming months.

In our view, after considering all the variables that we deem most important, the mosaic suggests that the best way forward is to “de-risk” portfolios where appropriate, while remaining invested with longer-term objectives in mind.  So that’s what we’ve done. Beginning in November of 2021 and continuing through December of 2022, we have taken several steps to shift portfolios to a more defensive posture. In some strategies, we’ve sold several stocks entirely with an emphasis on shifting investment away from companies with longer-duration growth prospects and into companies with strong balance sheets and more stable business models. In other strategies, we’ve reduced equity allocations altogether in favor of high-quality fixed income that is now yielding a nice income stream while we wait for a better investment landscape to develop.     

During times like this, it is extremely important to remember that we are long-term investors. The stock market is already down roughly 20% from its peak as a way of pricing in a slowing economy, and recession is not a foregone conclusion. As we’ve discussed in previous editions of “THE AEGIS”, if history is any indication, investors could realize above-average market returns after the worst of the economic woes subside. After all, despite whatever cockamamie click-bait predictions can be found on the internet, the world is not going to end in 2023. The single greatest free market economy in the history of the world will survive and continue to invent new and innovative technologies, develop medicines that improve health outcomes, create brand new industries, and make vast scientific discoveries that advance civilization and raise the standard of living for humanity. That, I can safely predict. —A. Morgan

Nothing contained in this post is intended to constitute legal, tax, securities or investment advice, nor an opinion concerning the appropriateness of any investment, nor a solicitation of any type and does not guarantee future results. The information contained in this post should not be acted upon without specific legal, tax and investment advice from a licensed professional. Past results are not indicative of future performance.