Market Update: Risky Business

Establishing well-reasoned philosophies in supporting data and then acting on those philosophies with discipline is important for investment success. The current highly expensive stock marketplace suggests that the disciplined investor should be reducing portfolio risk.
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Philosophy Anchored in Data

The best time to consider an emergency response is before a disaster actually occurs. When catastrophe strikes, humans, like all creatures, tend to revert to their basic instinctual responses (fear, worry, and panic), which may not result in an optimal outcome. When making decisions about investment exposures in times of market turmoil, it is a good practice to have established strategies and philosophies in place to aid decision-making during that time of duress.

The best philosophies are ones that investors can follow in a disciplined manner during such times and are also rooted in strong foundational supporting data. It is a good exercise to regularly reexamine the reasoning that established these philosophies in order to reaffirm their usefulness in decision-making. Decisions like how much risk exposure a portfolio should currently have will need to take into account the mix of available information, including the potential impact of COVID-19 variants, soaring inflation readings, all-time high market valuations, high levels of greed, and the drawdown of governmental economic supports.

Investing Lesson: Tolerate Small Losses, Seek to Avoid Large Losses

A major CWM core philosophy is “downside protection (limiting losses) is more important than participating in all market gains,” which is quite a bit different from the perennial investment industry call, regardless of life situation, to just “buy and hold” via index products that blindly provide exposure to large segments of the overall stock market. Those strategies are legitimate for specific circumstances, like clients participating in the CWM Starting Strong program, but may be inappropriate for those nearing or in retirement where maintaining wealth, and the lifestyle it provides, is a larger priority than getting even wealthier. The math shown in the below graphics demonstrates this reasoning.

A loss between 0 and 20% is largely redeemable via a similar level of portfolio growth, and your CWM team suggests this is a range of loss that must be tolerated as a cost of participating in a stock market that has regular annual drawdowns in that range. However, as the loss gets larger, that recovery becomes exponentially more difficult to achieve. Large losses are especially problematic for those investors that are dependent on their portfolios for lifestyle maintenance and/or lack the ability to make new meaningful contributions (example: retirees on a fixed or no income) during and after an inevitable market selloff.

Investors should not seek to eliminate all market losses, but the exponential need for recovery after large losses demands a greater risk focus for persons who could have their financial lives shattered given the right set of negative market circumstances. No one wants to sit across the table from their partner and discuss how many more years they have to delay retirement or who has to go back to work because they didn’t perform proper investment risk management prior to a market calamity.

Source: Win More by Losing Less. (June 30, 2021). Blackrock.

Putting the above demonstrated math into the real market scenario of the 2007 market high through the end of 2020 (see below graphic), a portfolio that only got a fraction (62%) of the up- or down-market move performed just as well as the buy-and-hold portfolio over the entire timeframe. Getting a similar return with a fraction of the volatility reduces the potential for uncomfortable conversations across the kitchen table, at least those about family finances!

The point is that it is not necessary to participate in every market gyration to get a good long-term result. Loss prevention, for many investors, should be a primary goal ahead of growing the portfolio’s value. Properly assessing market risk and the potential for an outsized loss scenario is key for enabling both wealth protection and future portfolio growth.

Source: Win More by Losing Less. (June 30, 2021). Blackrock. *Hypothetical investment or portfolio that captured 62% of each bull and bear market return of the S&P 500 when benchmarked to that index.

COVID-19: On Variant Watch

If loss prevention should be one of the primary aims of investors, then analyzing potential market risks, or potential negative catalysts, should be a focus for assessing potential future market outcomes. For well over a year now, the most well-known risk is the COVID-19 virus and its potential variants. The latest significant variant has been dubbed the “Delta” strain, which is reportedly more virulent than the original virus and has been found capable of infecting even vaccinated individuals. This variant is being blamed for the recent rise in both COVID-19 case numbers and hospitalizations across the United States and globally.

Fortunately, for now at least, these rising case numbers have not translated into similarly rising numbers of fatalities, with high vaccination rates being given the credit for that outcome. The big risk, of course, is that new infections may rise to levels that once again encourage government shutdown orders, which would undoubtedly be bad for the overall economy. Although, some may suggest that the economic shock would not be as severe as it was in early 2020 due to the experience that the business community has gained in operating through lockdowns over the last year plus.

Source: Coronavirus in the U.S.: Latest Map and Case Count. (July 16, 2021). The New York Times.

The current experience of the United Kingdom (U.K.), a highly vaccinated country with 69% of the population having at least one dose, as of July 16, is of particular interest because of early exposure to the Delta variant and sharply rising COVID-19 case numbers. Daily new case counts in the U.K. are worse than all but the 2020 winter peak and still rising fast. Fortunately, the daily death rate remains relatively muted compared to the past case spikes, giving some credence to the idea that while vaccines may not prevent infection, they may be staving off severe and potentially fatal cases. Everyone should hope that this continues to be the case.

Source: Tracking Coronavirus in the United Kingdom: Latest Map and Case Count. (July 16, 2021). The New York Times.

It should be kept in mind that most of the world lacks protection from even the original COVID-19 virus strain, let alone from any potentially more dangerous variants. While the developed world with its access to vaccines has become largely protected from the worst COVID outcomes, at least so far, a large chunk of countries have only a fraction of their populations inoculated. Unfortunately, this leaves ample opportunity for yet more COVID-19 related tragedy and the likely negative economic impact that comes along with it.

Source: Hatzius, J. (July 6, 2021). A Favorable Midyear Report. Goldman Sachs Economics Research.

The Unemployment Benefit Cliff Approaches

The potential for renewed COVID-19 related shutdowns is significant concern as the United States has yet to fully recover from the first round. Even after a strong economic recovery, unemployment remains near the worst levels of the 2008 Great Recession and below the worst parts of almost every post-war recession before that. Despite this still awful datapoint, many enhanced unemployment benefits programs are scheduled to sunset in September or even earlier in specific states.

Source: June Employment Report. (July 2, 2021). CalculatedRisk.

At this point, many states have opted out of the enhanced unemployment programs ahead of the September 6 expiration of the program, which means roughly 3 million people have already lost some of the federal benefits. By the September expiration date, almost 15 million Americans will have lost economic support, which will inevitably hit personal income levels and consumer spending data unless those individuals find employment, or the programs are once again extended (the original expiration was March 2021).

Source: Hatzius, J. (June 30, 2021). The Inflation Risks from Stronger Low-End Wage Growth. Goldman Sachs Economics Research.

Fortunately, in some good news for current unemployed persons, available job openings and small businesses’ hiring plans are the highest they have ever been. It appears that there is plenty of potential employment opportunity for those losing benefits if skills and locations can be matched up.

Source: Job Openings: Total Nonfarm. (May 2021). The Federal Reserve Bank St. Louis.

Source: Sonders, L. et. al. (June 8, 2021). 2021 Schwab Midyear Market Outlook. Charles Schwab.

Inflation Levels are Spiking, But Lower Levels Still Expected into the Fall

Price inflation has suddenly become a hot topic with regular reports of sharply rising prices for expenditures like food, housing, and other necessities. The most recent consumer price index (CPI, a primary inflation measure) report issued by the Bureau of Labor Statistics put the year-over-year rise in consumer goods prices at 5.4%, the highest level since 2008 and well above forecast expectations.

Source: Reid, J. (July 13, 2021). Is 2022 Transitory Too? Deutsche Bank.

However, that data is skewed by the sharp increase in costs for used vehicles, up over 10% from just a month ago.1 That is a rate of change that is unlikely to be repeated and should serve as a drag on future inflation pressures in the future.

Source: Hatzius, J. (June 29, 2021). Supply Chain Disruptions and the Inflation Outlook. Goldman Sachs Economic Research.

Unfortunately for companies, the Producer Price Index (PPI, input cost prices) shows that inflationary pressures are rising even faster for materials than they are for end consumers, with most companies electing not to pass through cost increases, presumably to protect their market share. This is not great for company profit margins at already high levels of stock market valuation or related future investment return prospects. Historically, when the PPI is greater than the CPI, low future return prospects exist for the upcoming 6 and 12 months (just 2.3 and 4.3% respectively) versus environments where the opposite is true.

Source: Sonders, L. et. al. (June 8, 2021). 2021 Schwab Midyear Market Outlook. Charles Schwab. CWM Data Analytics.

Like unemployment, one of the biggest sources of this inflationary pressure is the 2020 COVID-19 shutdowns that resulted in extreme supply chain disruption. The lead time to procure manufacturing materials is at never-before-seen levels. Businesses cannot sell what they cannot build, and available supply will inevitably sell at a higher price because of the outmatched demand.

Source: Golle, V. (June 1, 2021). Factories in U.S. Face Record Wait Times for Materials. Bloomberg.

Fortunately, there remains ample global production capacity, which further supports the idea that high levels of inflation should be temporary or “transitory,” as commonly heard in the media, as manufacturing comes online and supply chain issues are solved. Per Economics 101, higher prices and a stabilized global supply chain should encourage new production to come online, thereby feeding supply and eventually resulting in falling end consumer prices.

Source: Hatzius, J. (June 29, 2021). Supply Chain Disruptions and the Inflation Outlook. Goldman Sachs Economic Research.

While current inflation data seems scary, it is likely that inflationary pressures will dissipate in the future if the global economy can continue to recover from COVID-19 related shutdowns, supply disruption, and high unemployment. For more of the CWM team’s insights on inflation, watch our video here.

All-Time High Valuation Levels and Investor Greed Remain the Signs of Danger

To discern the current proper course of action, information like the above must be considered within the context of the current investment environment, which is presently the most highly valued (i.e., expensive) on record as judged by the market cap-to-gross domestic product ratio. High market valuations suggest a marketplace that is not pricing in the very real risks mentioned above. All the above-mentioned items would not seem as dangerous if markets appeared to be pricing in their potential occurrence (i.e., valuations were currently lower to reflect the risk).

As most CWM clients know, a strong investment philosophy of the team is that expensive things are dangerous. While positive price momentum and supportive governmental action do help promote those high values; high market valuations, high levels of investor greed, and future economic uncertainty do suggest that the overall marketplace structure is fragile and susceptible to negative shocks. Potential shocks that could result in a swift loss of market value, as was seen in early 2020. As it stands, the overall stock market seems priced for a perfect future outcome, which leaves ample room for disappointment and downgrade.

Source: CWM Factor Groups. (July 16, 2021). CWM Data Analytics.

Taking a closer look at valuation — the primary current market risk, in your CWM team’s opinion — the combined U.S market capitalization is presently (as of July 12, 2021) 207% of U.S. gross domestic product (GDP, a measure of total economic output). This signifies that the combined value of the U.S. stock market is over two times the economic output of the country. Historically, market capitalization is below 100% of U.S. GDP. Returning to the long-term mean (or average) represents a ~57% decline from the current level. Just to get back to simply “overvalued” (the two standard deviation level) requires a drop of ~25%. The market does not need to fully mean revert to have nasty sell off.

Source: Market Cap/GDP. (July 12, 2021). The Federal Reserve Bank of St. Louis & CWM Data Analytics.

Valuation is high not only in GDP terms, but also in terms of company earnings as valuation growth has expanded versus earnings by the widest margin since 2000, just prior to the multi-year Dot-Com crash.

Source: Authers, J. (June 10, 2021). Bond Front-Runners Don't Care About Inflation. Bloomberg.

Higher valuations, of course, feed investor confidence, which at some point turns into irrational greed. Periods following high measurement of greed historically have provided significantly lower returns than less optimistic market environments.

Source: Wurster, R. (Q3 2021). Quarterly Chartbook. Charles Schwab.

At this time, your CWM team remains concerned primarily about all-time high valuations and levels of investor greed/euphoria, especially considering the possibility that markets may, at least in part, be built on liquidity driving policy decisions of government and/or central banks that could be changed in an instant. Expensive markets do not always crash, but they frequently are followed by a period of very low long-term returns.

For now, a smart course of action is probably taking limited risks that provide some possibility of upside participation, in case markets do continue to rise, while remaining mostly defensively postured overall while awaiting market environments with better future return prospects. Since downside protection is more important for investment success than upside participation, it is not hard to see how the current investment setup requires a high degree of caution. Sitting out significant market downside offers its own reward, even though it often requires a great deal of patience to do so prior to that occurrence.

Please pass this article on to anyone you know who may be interested in or might benefit from the information. We are always looking for more great clients like yourself and would welcome any opportunity to assist them.

If you have questions or comments about the above subjects or other investment topics, I would love to have a conversation! Feel free to email me or, if you are interested in more regular financial tidbits, follow me on Twitter.

P.S. Bad days happen, sometimes they can still result in something beautiful.


1Reid, J. (July 13, 2021). Is 2022 Transitory Too? Deutsche Bank.

Past performance is no guarantee of future results. The S&P 500 is an unmanaged index comprised of 500 widely-held securities considered to be representative of the stock market in general. You cannot directly invest in the S&P 500 index. Dollar Cost Averaging does not assure a profit or protect against a loss. Such a plan involves continuous investment in securities regardless of fluctuating price levels.

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