EVERYTHING IS BROKEN

“Broken bonds, broken coins

Broken stocks, broken memes

Charts are filled with broken dreams

Seem like every time you stop and turn around

Something else just hit the ground”

(Apologies to Bob Dylan)

To understand what’s happening in markets today, you must first comprehend the era you just lived through. Fortunately, we have charts for that:

Over the past dozen+ years Global Authorities were given discretionary power to fabricate money and interfere with price discovery. In so doing, they put the cart of asset prices before the horse of enterprise.

An illusory prosperity developed from the morphine drip of stimulus, bailouts, and helicopter money.

Beginning in early 2020, the Fed was implementing $120 billion of Quantitative Easing (buying up US debt) per month. This is in addition to $5 trillion in fiscal stimulus. The result was a 120% rise in stocks from the pandemic low to the recent high, which created multiple distortions along the way.

Charts courtesy L.Roberts

The enormous surge in M2 (money supply) created the inflationary surge we are seeing now and supported rampant market speculation. The “sugar rush” of liquidity could not be contained given a lack of productive capacity in the economy.

Most of the stimulus during 2020-21 went to keeping consumers and businesses solvent despite the reduction in productivity that came with the pandemic and lockdowns.

In the aftermath of this new money creation, we don’t have more commodity production capacity, manufacturing capacity, or a more educated workforce.

The surge in the repurchase of shares over the last decade was one of the more significant supports to the stock market (because it is mostly the major market-cap-weighted names that can afford multi-billion share buybacks).

The magnitude of buybacks would not have been possible without an extended period of zero interest rates. Companies were able to financially engineer their earnings by borrowing at next to nothing and using the cash to buy back their own shares.

The chart below via Pavilion Global Markets shows the impact of buybacks on the market over the last decade:

According to Pavilion, in the absence of share repurchases, the stock market would not have been pushing record highs of 4800 but instead levels closer to 2800. This would mean that stocks returned a total of about 3% annually over those years.

Repeated rounds of monetary interventions also created ‘moral hazard’ in the financial markets. The massive interference from Global Authorities provided a perverse incentive to take on extreme forms of risk, from speculative IPOs to SPACs to cryptocurrencies. Investors believed the Fed was protecting them from the consequences of risk.

The lesson taught to investors was that the Fed would bail out any market decline. This became known as the “Fed Put”.

WHERE IS MY BAILOUT?

Past market sell-offs were quickly fixed with successive rounds of intervention, but today that appears unlikely (for now).

As opposed to previous market routs where inflation was tame, such is not the case this time. In fact, it could not be more opposite as inflation is running at multi-decade highs, and the Fed is pushing the most aggressive monetary tightening campaign ever.

Yet everyone has a pressure point, including the Fed.

Given the importance of “financial stability” to the Fed, it’s quite possible they will abandon their inflation mandate to support the financial system, especially if/when something large breaks.

The extreme buildup of debt and leverage in the financial system means things can quickly spin out of control. Significant damage to the credit, financial, and real estate markets might force another policy flipflop sooner rather than later.

When Paul Volcker famously raised rates to 19% in 1980 to slow down money supply growth, total debt (public and private combined) was 160% of US GDP.

Today, total debt is 370% of GDP. So, a much lower interest rate would cause widespread insolvencies and economic contraction.

WHAT ARE YOU DOING TO PROTECT ME?

Most people invest to obtain their goals with as little risk as possible, and most would prefer avoiding large drawdowns, even at the expense of growth.

A top goal for any fiduciary should be to provide an investment approach that includes risk management solutions.

This is especially true for clients nearing retirement or already retired. Bear market losses can be devastating when time is not on your side.

Drawdown math can be daunting. If you are -25% this year (not uncommon), it takes a 33% rally just to break even, assuming things don’t worsen from here. And if you are 50% confident this will happen, your expected outcome is a gain of 16.5%, which still leaves you underwater.

Those favoring a passive buy & hold approach must expect several severe drawdowns over a full market cycle. In the last two years alone we’ve seen two 25%+ slides, with the current one unresolved. Some may shrug, which is fine. You can’t walk in another investor’s shoes.

For us, what matters are risk-adjusted returns. This is a measurable goal, comparing returns to volatility. You can have a bumpy ride or a smooth ride. Smooth rides result in high Sharpe Ratios, an industry-wide performance standard. It is impossible to achieve high Sharpe’s with big drawdowns.

Here are some risk-management guidelines we follow 24/7:

1. Technical analysis of trends and market sentiment. Early last fall “market breadth” alerted us to a rapid deterioration in trend quality which presaged this year’s stunning decline. It was our canary in a coalmine.
   

2. Diversify by strategy, not just by asset class or geography. We deploy several ‘alternative’ strategies designed to perform during periods of market stress. These include ‘short’ and options strategies. It is not enough to place the burden of diversification onto a single asset class like bonds, as many do. This is especially true in 2022.
   

3. Raise cash when risk conditions flash red. Cash is not a long-term solution, but it is a port of calm.
   

4. Stop losses. Every position within a portfolio should have a point where it is “stopped” out. We rely on “technical tools” for setting and managing these levels. Having an exit strategy for both winners and losers is an essential part of active management.
   

5. Hedging. This is a catch-all for the tactics described above. Remember that most large serious investors, from pension plans to insurance companies to Warren Buffet, are all active hedgers.
   

6. Avoid behavioral bias. Behavioral Finance reveals that humans are often irrational in making investment decisions. Herding, anchoring, loss aversion, and confirmation bias are among the most common psychological pitfalls. You can find more on this here.
   

7. Remove emotion from the equation. A distinct advantage of systematic strategies is that algorithms feel neither fear nor greed.

BONUS CHART:

BONUS CHART 2: