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What a difference "two tenths" can make

What a difference "two tenths" can make

| November 11, 2022

It's hard to drive a vehicle (or an economy) while looking in the rear view mirror.

Last month, we wrote about how we thought the Fed was being a bit too aggressive in its interest rate hikes.  Many of the oft quoted indicators are backward looking and take a long time to show improvement. But the evidence was strong that inflation was easing.  We thought that the Fed was emphasizing the wrong stuff...

We also recognized that Fed needed to establish its credibility as Inflation Fighters and so had signaled that policy would err on being too tight rather than too loose.  The market did not receive this news well, of course, and stocks weakened in September.

October saw some improvements in inflation indicators, but these readings were not yet enough to slow the pace of interest rate hikes.  Meanwhile, the economy and employment remained strong, further complicating the Fed's job and investors' ability to discern policy direction.  So, the rate hikes persisted.

Yesterday things changed -- at least a little.  

The Bureau of Labor Statistics released the Consumer Price Index for the month of October showing that prices rose by 0.4%, or at an annual rate of 7.7%.  Economists' estimates compiled by Dow Jones were for prices to rise by 0.6% and 7.9% respectively.  That two tenths of one percent difference precipitated a sharp rally in stocks with the Dow Jones Industrial Average advancing by nearly 4%, the S&P500 by more 5%, and the NASDAQ Composite by 7%+.  Treasury yields also fell sharply.

Does this mean that we're "out of the woods" and that a new bull market is underway?  Perhaps not.  But long term investors understand that buying opportunities periodically come from economic dislocations. We are in one of those times.

As we wrote last month, to position for the next bull market, investors will likely have to do what is hardest -- wade into the deep end of the pool and take on higher levels of risk. This could mean increasing allocations to high yield debt, small cap stocks or even venture capital funds. 

The challenge is that the Fed isn't done, and more volatility should be expected.  Such aggressive shifts would look wrong for a while, and losses could be painful.  With our portfolio allocations close to the benchmark for US stocks, underweight international stocks, and with little current exposure to high yield debt, we are content to wait for clearer signs that volatility is subsiding before ramping up risk levels. 

For years, we have advocated for sizable allocations to alternative investments for clients who could invest in them.  We still believe strongly in seeking the opportunity to earn equity-like returns without equity market risk.  A portfolio of what we call "Independent Engines of Growth" is what we have long sought to build for our clients.  We will continue to do so.  Recent successes in private equity, real estate, self-storage, and renewable energy infrastructure confirms that we were on the right path.

For many investors, the "negative" aspects of alternatives -- namely tax complexity (K-1 reporting) and illiquity -- pale in comparison to the potential benefit of uncorrelated financial returns and measurable social impact.  We're still in the "alts camp" and welcome the opportunity to discuss this with any investor who feels that they are too exposed to market forces in their portfolio allocations.