Posts

Part 3: A Lookback at Q1 and Portfolio Impact

If you’re talking with friends about market volatility, pessimists may say “downward is the only way forward,” but optimists like us will continue to share the sentiment that “We Will Prevail,” which is based on our assessment of history, data, and our go-forward market outlook.

For those of you who caught that subtle reference from the movie Inception, maybe you’re getting a taste for how big of a cinephile I am. For those who didn’t – no sweat; let’s wrap up this series of blog releases by assessing the first quarter’s market performance. 

Before diving in, it’s important to note the macroeconomic trends that are primarily driving market risk: 1) the tightening of financial conditions and 2) the war in Eastern Europe. The Federal Reserve and other Central Banks are raising interest rates to calm inflation. Meanwhile, Russia’s invasion of Ukraine has had knock-on effects economically, particularly in Europe. With that in mind, see below for how markets are ending the first quarter.

Exhibit A – Asset Class Performance in 2022

Source: YCharts

The Laggards

Looking at Exhibit A, bonds, followed by US Large Growth names (i.e., AMZN, AAPL), and international stocks (i.e., emerging markets and Europe stocks) are lagging. 

  • Bonds Begrudgingly Behind: recent bond volatility can be attributed to inflation and rising interest rates. Inflation diminishes the purchasing power of a bond’s interest payments, while interest rate hikes apply downward price pressure on the value of a bond (you can now find a similar bond in the market yielding a higher rate). 
  • Growth Names Falter: This asset class includes larger companies that are typically more expensive (e.g., Amazon, Apple), with stock prices that are highly dependent on future earnings growth. However, rising interest rates are raising the cost of borrowing, which depletes the value of a company’s future cash flows and are skewing growth names to the downside.

Exhibit B – How Are Big Tech Stocks Doing?

  • International Stocks Give Up Ground: At the start of the year, international stocks including European, Australian, and Far East (EAFE) and Emerging Markets (e.g., China, Brazil) equities outperformed domestic markets. US markets were being punished for an overweight to growthier names amid interest rate hikes. Most recently, the Russian invasion of Ukraine has dampened investor appetite for the international scene, overturning the region’s initial outperformance. 

Exhibit C – The Race Between International and the US

Source: YCharts

Leaders

  • Gold Shines Bright: After a lackluster 2021, gold regained its shine this past quarter. Geopolitical uncertainty, coupled with a distrust of central banks to tame inflation, has resulted in sizable outperformance from the precious metal.
  • Value Names Triumph: While US Large Growth suffers from tighter financial conditions, investors are paying more attention to company profitability. US Large Value typically consists of companies that are larger, have a long-standing business model, and proven profitability. Examples include Target, Walmart, and Disney. 
  • S&P 500 Recovers: After a weak start to the year (at one point being down 12% year-to-date), the S&P 500 has largely regained lost ground. Although the expectation of rate hikes remains a risk to the broader index, domestic markets have been favorable given a relatively unthreatening economic impact from the Eastern European war.

Takeaways, Portfolio Impact and Our Game Plan

Takeaways – Is the 60/40 Portfolio Dead? A 60/40 portfolio has long been coveted as the standard for a “moderate” risk investor, with a 60% allocation to stocks and a 40% allocation to bonds. The bond allocation is meant to mitigate volatility during downturns, but with today’s largely challenged bond environment, the asset class has not cushioned investors during this recent equity sell-off. 

Source: YCharts

Exhibit C includes the annual returns of a 60/40 portfolio, the global stock index (Ticker: ACWI), and the passive bond index (Ticker: AGG). Over the years, bonds have served as a protector against equity volatility, capturing a fraction of an equity market drawdown. However, thus far in 2022, bonds are selling off more than equities. Therefore, investors should not expect to receive similar risk-adjusted returns they did in the past for a traditional 60/40 portfolio – at least in the near term.  

Portfolio Impact – Thinking Outside the Box: With the 60/40 structure in jeopardy and bonds to endure some short-term pain, a different approach should be considered. Enter Warren Street’s Real Assets sleeve – or what we like to call “Diversifiers” – which consist of real assets that typically benefit from inflation (i.e., gold, natural resources, and real estate).

Last summer, after acknowledging the adverse circumstances of the bond realm, Warren Street proceeded to underweight bonds and overweight diversifiers within blended models on top of initiating a position in a commodities fund. This trade has rewarded our portfolios and cushioned the bond and equity sleeves amid the most recent 2022 sell-off.

Our Game Plan – An International Resurgence: With Diversifiers outpacing stocks, our team rebalanced real assets into equity weakness, effectively selling high and buying low. We will continue to monitor momentum within Diversifiers and the bond landscape before returning to our neutral weights. 

The looming question remains on our equity strategy, which incurred relative underperformance attributed to our overseas exposures. Although Russia’s military invasion overturned initial outperformance against domestic markets (see Exhibit C), we believe there is significant headroom for an international equity resurgence should the war abate. 

Albeit still unpredictable, Ukrainian resistance is increasing the probability for a ceasefire. Couple that with the pandemic transitioning to an endemic, a US market that is more sensitive to central bank reserve tightening and attractive valuations overseas, we continue to remain optimistic about our clients being rewarded for their patience and for avoiding home-country bias. 

Conclusion

You’ll hear us say it time and time again: control what you can control. Throughout this quarter, our team has tax-loss harvested in accounts amid sell-offs, rebalanced diversifiers into equity weakness, and thoroughly assessed the impact of conditions #1 and #2 mentioned above in our portfolios.

Outside of portfolio strategy, we’ve made strides in uploading more content on socials, blogs, and video formats to upkeep communications beyond our client meetings. We encourage you to read recent blog releases pertaining to the war in Ukraine and to give us a follow on social media. 

Ultimately, the movie inception is about planting an idea and allowing it to grow. I’m no extractor or architect of dreams, but let me attempt to fortify my parting idea once more: “We Will Prevail.”

Phillip Law, Portfolio Analyst

Wealth Advisor, Warren Street Wealth Advisors

Investment Advisor Representative, Warren Street Wealth Advisors, LLC., a Registered Investment Advisor

The information presented here represents opinions and is not meant as personal or actionable advice to any individual, corporation, or other entity. Any investments discussed carry unique risks and should be carefully considered and reviewed by you and your financial professional. Nothing in this document is a solicitation to buy or sell any securities, or an attempt to furnish personal investment advice. Warren Street Wealth Advisors may own securities referenced in this document. Due to the static nature of content, securities held may change over time and current trades may be contrary to outdated publications. Form ADV available upon request 714-876-6200.

Part 2: Assessing War and the State of the Global Economy

Don’t Miss the Big Picture 

With news outlets centered on Eastern Europe, it is easy to miss the bigger economic picture both globally and domestically. For a broader assessment, it helps to understand how Russia fits into the global economy. Prior to the invasion, the Kremlin represented just 3.11% of global GDP.  

To further illustrate, Exhibit A and Exhibit B portray the size of Russia’s economy, population, and percent makeup of the global stock market compared to other countries. Looking at Exhibit A, Russia has the largest population of this subset, yet its economy (the size of the bubble) is smaller than Texas. Thus, the war’s direct effect on global growth was already limited even before indices deemed Russia as “uninvestable” or before western parties imposed sanctions.  

Exhibit A – Russia’s Economy is Smaller Than Texas 

Exhibit B – Russia is Miniscule compared to the US, China, and India  

Zooming out in Exhibit B, you can assess just how small Russia is relative to the United States and its Asian neighbors China and India.  

The State of the West 

Before discussing other nations, let’s cover our home turf. Within the United States, we have successfully fended off the Omicron wave. COVID-19 data is trending in the right direction, pandemic related pressures (i.e., labor market, car prices) are slowly easing (Exhibit C), and consumer balance sheets are rock-solid (Exhibit D).  

Exhibit C: The Labor Market is Loosening, and Inventories are Building 

Exhibit D.1: Debt as a % of Consumer Incomes

Exhibit D.2: Consumers Have a Record $2.4T in “Excess Savings”

Although the threats of additional COVID-19 variants and prolonged inflation linger, our economy is expected to produce above-trend economic growth (see Exhibit E). In fact, economists remain optimistic about the US economy, with the median 2022 real gross domestic product forecast only revised 0.10% downwards after the invasion of Ukraine.  

Other major economies (particularly in Europe) are more at risk for an economic slowdown attributed to higher energy prices (i.e., over $120/barrel for Brent Crude driven), or what we call “pain at the pump.”  

Although Europe derives 40%+ of its natural gas from Russia and Ukraine, we expect that new measures targeting energy independence and militaristic efforts will have positive long-standing effects on European growth despite interim road bumps. For some near-term perspective, European nations are still expected to grow GDP above their long-term forecasts in 2022 (see Exhibit E).

Exhibit E: How Much Are Our Economies Expected to Grow in 2022?

Commodity Chaos – Not to be Overlooked 

Although the war’s direct effect on global growth is likely to be meager, indirect pressures on commodity prices are a larger concern, as they may diminish the purchasing power of disposable incomes. Russia is the world’s second largest oil producer behind the US, and accounts for 12% of global production. Also, Russia and Ukraine make up 25% of global wheat exports, 33% of global corn trade, and 80% of sunflower oil production.  

What happens if sanctions are imposed, or if nations surrender agricultural practices to fight on the battlefield? The price of electricity in your factories will rise. Middle eastern nations reliant on wheat imports (i.e., Egypt and Lebanon) must ration appropriately. Chinese-grown hogs – which feed on corn – are more expensive to raise. Lastly, the price of that bag of Ruffles (made from sunflower oil) is expected to increase. 

Exhibit F: Commodity Prices Are Rising

Where Do We Go from Here? 

Could this lead to inflation? Yes – we have already seen commodity prices surge exponentially. Does this mean that the US economy will fall to its knees? The probability of that is very low.  

After all, two-thirds of our nation’s economy is consumption-driven, and with consumers looking healthy and a central bank easing the economy into a higher rate environment, it is hard to envision a full-scale economic disaster unfolding. Even if we run into a recession, perhaps it will be much smaller than our recent lived experiences of the Great Recession and the Great Lockdown (2020 COVID-19 Pandemic).  

Our European neighbors will be more vulnerable over the next three months, especially with an energy embargo on Russia still on the table. However, between German Chancellor Olaf Scholz mobilizing its military (for the first time in 20 years), renewed sentiment on energy independence, and a newfound unity amongst the entire West, the European economy is exuberating a different luster and willingness to grow than it did in previous years. Should this war abate, we believe Europe could resume course towards full recovery and investors with allocations will be rewarded. 

A Stronger West, Once the War is Put to Rest 

Ultimately, our sentiment from part 1 of this series that “We Will Prevail” has not changed. We have endured many instances of short-term pain and come out victorious. This time is no different. I am confident that our economies – particularly the West — will emerge stronger and more united after this war is put to rest.  

Stay tuned in part 3 where we discuss asset class performance and portfolio impact! 

Phillip Law, Portfolio Analyst

Wealth Advisor, Warren Street Wealth Advisors

Investment Advisor Representative, Warren Street Wealth Advisors, LLC., a Registered Investment Advisor

The information presented here represents opinions and is not meant as personal or actionable advice to any individual, corporation, or other entity. Any investments discussed carry unique risks and should be carefully considered and reviewed by you and your financial professional. Nothing in this document is a solicitation to buy or sell any securities, or an attempt to furnish personal investment advice. Warren Street Wealth Advisors may own securities referenced in this document. Due to the static nature of content, securities held may change over time and current trades may be contrary to outdated publications. Form ADV available upon request 714-876-6200.

Part 1: We Will Prevail

“There are decades where nothing happens; and there are weeks where decades happen.”

– Vladimir Lenin

The words of Lenin, who led the Russian Revolution in 1917, are ringing true in his own country over 100 years later. Russian Prime Minister Vladimir Putin’s decision to invade Ukraine took the world, and financial markets, by storm. For investors, initial instincts may prompt feelings of worry, and rightfully so.

After all, homes are collapsing, buildings are burning, and civilians are being displaced in what publications are calling the biggest war in Europe since 1945. First and foremost, we empathize with the human concerns and humanitarian disaster resulting from Russia’s full-scale invasion of Ukraine. We believe that a broad understanding of the market’s relationship with geopolitical crises, the state of the global economy, and the war’s impact on broad asset classes will help investors navigate this turbulent time.

This series will aim to address the concerns that arise for investors and global markets during such times.

Weathering the Storm

In an era where G20 nations are accustomed to diplomacy, the impact of war on markets may seem foreign. However, we can turn to history to help distinguish relationships between capital returns and warfare. Below is a chart showing the growth of $10,000 invested in the S&P 500 since 1950, overlayed with a myriad of events.

Exhibit A1

Looking back, the S&P 500 grappled with numerous instances of geopolitical turmoil, nationwide systemic meltdowns, and a global pandemic. Despite these vulnerabilities, notice the trend and direction of that initial $10k: it consistently recovers and grows over time Furthermore, Exhibit B features returns 12, 24, and 36 months after the market bottomed in each war.

Exhibit B 

These charts convey two things:

  1.  Despite volatile periods, investors have generally been rewarded for putting their capital at risk.
  2.  Human beings are incredibly resilient. We’ve lived through arduous events, gritted our teeth, and made it to the other side.

Some people are comparing this conflict to World War II, but we disagree given that the battle is regionally contained and the US is unlikely to become directly involved. The conflict can, and likely will, get worse. But the probability of another world war is low.  

The outcome of Russia’s invasion is difficult to predict. Whether Putin succeeds in establishing a puppet government in Kyiv or a ceasefire is negotiated, we have faith that humankind will persevere and that capital will continue to seek the most efficient allocators, leading to long-term positive returns. In other words, we will prevail.

Phillip Law, Portfolio Analyst

Wealth Advisor, Warren Street Wealth Advisors

Investment Advisor Representative, Warren Street Wealth Advisors, LLC., a Registered Investment Advisor

The information presented here represents opinions and is not meant as personal or actionable advice to any individual, corporation, or other entity. Any investments discussed carry unique risks and should be carefully considered and reviewed by you and your financial professional. Nothing in this document is a solicitation to buy or sell any securities, or an attempt to furnish personal investment advice. Warren Street Wealth Advisors may own securities referenced in this document. Due to the static nature of content, securities held may change over time and current trades may be contrary to outdated publications. Form ADV available upon request 714-876-6200.

Footnotes & Sources:

  1. Chart is not log-scaled and thus understates market return volatility.

Market Volatility – “A Few Minutes with Marcia”

Volatility measures the frequency and magnitude of price movements, both up and down, that a financial instrument experiences over a certain period of time. The more dramatic the price swings, the higher the level of volatility.

Learn the basics of market volatility with Marcia Clark, CFA, MBA.

Watch:

For those who prefer to read!

Welcome to A Few Minutes with Marcia. My name is Marcia Clark, Senior Research Analyst at Warren Street Wealth Advisors. Today we’re going to talk about the 4th quarter 2018 stock market dive and 1st quarter 2019 rebound in an attempt to understand more about market volatility.

Prior to 2018, the stock market had experienced 2 years of unusually low volatility, despite a few bumps along the way. After a mixed start to 2018, the Dow Jones Industrial Average looked like it was back to its winning ways, then came the 4th quarter tumble. Investors were caught by surprise by the huge swings in market prices – volatility – and started selling stocks like crazy. To better understand these market dynamics, let’s put the recent activity into context.

You may have heard of a common measure of market volatility called the ‘VIX’ – the Chicago Board Options Exchange volatility index. The VIX measures expected future volatility by evaluating the prices of put and call options traded on the exchange. If you’re looking at the slideshow, you can see how much calmer the VIX index was during the quiet years of the stock market, especially in 2017. As the market swooped up in late 2017, expected future volatility spiked shortly thereafter – remember that volatility can spike when prices go up as well as down.

When the market gave back some of its gains in early 2018, the volatility index fell back as well. Then came the market tumble in late 2018. The VIX index starts jumping around like a Richter scale during an earthquake. As we move into 2019, even with the recent pick up in volatility the graph shows that the VIX is at a pretty normal level compared to prior years. We’re just not used to ‘normal’ volatility anymore.

Where do we go from here? No one knows for sure, and if anyone says they can predict the future they’re kidding themselves and their clients. What we can say is that financial markets react to rumors and headlines, many of which don’t fundamentally change the financial landscape. This ‘knee jerk’ reaction causes market volatility, and this volatility is normal. In fact, active investment managers appreciate market volatility, because market dips based on headlines rather than fundamental changes in the economic landscape give investors with a strong stomach and an evidence-based outlook the ability to buy good assets at cheap prices. If all goes well, those assets will recover their value plus more over time, and patient investors will be rewarded.

 

Marcia Clark, CFA, MBA
Senior Research Analyst
Warren Street Wealth Advisors

Warren Street Wealth Advisors, a Registered Investment Advisor. The information contained herein does not involve the rendering of personalized investment advice but is limited to the dissemination of general information. A professional advisor should be consulted before implementing any of the strategies or options presented. Any investments discussed carry unique risks and should be carefully considered and reviewed by you and your financial professional. Past performance may not be indicative of future results. All investment strategies have the potential for profit or loss. 

 

 

DISCLOSURES

Investment Advisor Representative, Warren Street Wealth Advisors, LLC., a Registered Investment Advisor

The information presented here represents opinions and is not meant as personal or actionable advice to any individual, corporation, or other entity. Any investments discussed carry unique risks and should be carefully considered and reviewed by you and your financial professional. Nothing in this document is a solicitation to buy or sell any securities, or an attempt to furnish personal investment advice. Warren Street Wealth Advisors may own securities referenced in this document. Due to the static nature of content, securities held may change over time and current trades may be contrary to outdated publications.

Form ADV available upon request 714-876-6200