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Full Cycle Investment Process Or Performance Chasing?

What fascinates me about the Old Wall’s latest fascination with “AI” is that they love it and they’re big time long of it (invested), but they definitely don’t want to apply it to their economic nowcasting #process.
Keith McCullough

Stocks reach extremes against bonds with no historical precedent.

Equity earnings estimates assume continued gains, despite recent actual earnings declines and high and rising recession probability.

This week, US Industrial Production Growth has #slowed from +1.5% y/y in JAN to +0.2% in MAY, US Retail Sales Growth has #slowed from +7.4% y/y in JAN to +1.6% in MAY.

For the S&P 500 earnings, Q1 was -3.6%, Q2 will likely be down -6-12%. On the latest Q1 data both earnings and sales declined for technology stocks in the Nasdaq 100.

Nevertheless, last week saw record weekly inflows to technology funds. On Thursday June 15, 1-day Call Option Buying in SPX of 1.8 MILLION contracts was an ALL-TIME HIGH.

After excess liquidity over recent months, liquidity is now being withdrawn significantly.

Are core inflation real yields, at zero, too low for the Fed to skip or pause?

What is the long term performance record of investors who chase return to unprecendented market extremes? See the results.

Return chasing is shown to be the path to long term underperformance. Adopt Best Investors standards instead.

Nasdaq 100 index correlations with other assets have been disrupted by a surge in mega-cap technology stocks. There is an extraordinary divergence of Semiconductor sales from stock prices, and the Nasdaq 100 from the 10 year Treasury Yield. How durable is this technology stock rally and what is the optimal medium term strategy?

The divergence of the Nasdaq 100 from the 10 year yield is also one for the record books.

Stocks and bonds are pricing different futures. S&P 500 Earnings Per Share are expected to grow, without any dip, at around 10% pa through 2025 to new record highs. Meanwhile , 2yr Yields (vs 1yr) are implying the most dramatic Fed cut cycle ever.

This combination of earnings growth and interest rate cuts has no historical precedent.

Even so, the forward earnings yield of the S&P 500 is as tight as it has ever been to Treasury 10 year yields.

Yet investors can’t resist buying outperforming stocks on the move regardless. Recent flows into tech stocks have been astonishing.

Even though on the latest data both earnings and sales are declining for technology stocks in the Nasdaq 100.

For the S&P 500 earnings, Q1 was -3.6%, Q2 will likely be down -6-12% according to Hedgeye.

Bullish narratives are very powerful when there is excess liquidity. Record liquidity in the first half of 2023, due to the debt ceiling, may have been a factor. Providing fuel for any rally, along with excessive government spending and buybacks.

Another question, and source of support, is whether the Fed should be considering a pause with core inflation still around 2.5 times the inflation target at around a zero real yield on the Fed Funds rate and record speculation in the markets? The chart below shows generally higher real interest rates prior to 2008.

Clearly the Fed sees the problem, from its statements and dot plot this week.

“We See that it Tells Us that We Need to Do More”
Jerome Powell, Fed Chairman

However, the challenge is substantial. The Fed is reaching the limits of its ability to manage the current combination of growth, inflation, and financial stability.

Let’s get some perspective on the Fed’s inflation record since it has had full discretion since 1970 when the gold link was abandoned. The CPI is up a multiple of 8 times! Furthermore, the Fed’s inflation record has deteriorated badly in the last few years. It has a great deal to prove as regards its inflation credibility.

Liquidity is now being withdrawn dramatically.

Deutsche Bank strategist Steven Zeng said in a recent research note, net bill issuance of $400 billion is expected in June, followed by $500 billion between July and September. In total, Zeng estimated $1.3 trillion in net bill issuance by the end of the year. All of which could well drain significant liquidity from the system.

Meanwhile, extreme recession risk seems to be suggested by the data and markets.

The current yield curve inversion far exceeds anything in recent history.

Continuing claims are also indicating recessionary levels. The labor market is typically one of the last components of the economy to turn down in a recession.

Same store sales in nominal terms have significantly declined to close to zero over the last 18 months.

World Growth is Chronically Weak

According to the World Bank, global growth in 2023 will slow to the lowest level since the 2008 financial crisis. Very uncharacteristically the World Bank (WB) is predicting the beginning of a potential Global Recession, following recent IMF growth downgrade.

The WB states “The world economy remains hobbled. Besieged by high inflation, tight global financial markets, and record debt levels, many countries are simply growing poorer.” The WB sees growth in advanced economies slowing from 2.6% in 2022 to 0.7% this year and remaining weak in 2024.

One of the best barometers of world growth, shows a decline of China exports.

Even as Europe has returned to recession.

When Investors chase returns like this, how are they likely to perform?

In investment bubbles, all the emotional extremes will likely be experienced. This will test every investor and outcomes through the full bubble will be likely very different from short term performance.

For example, take the case of the technology ETF ARKK.

Central to this example is that it reveals how many investors naturally behave. ARKK embraces high risk technology stocks. Most investors can’t resist short term high returns when they see it. They typically chase that when they see it, abandoning other investments.

Their investment thesis is therefore an exciting narrative, and evidence of strong short-term performance. It is not clear that any other criteria is involved. What is clear is that assets under management follow near term short term performance. Investors chase returns. Here is the record for ARKK a popular technology ETF. First it is clear that assets follow returns:

The results shown below are simply tragic. Not only has the fund had very poor long term results, but investors have done far worse through their own investment behavior.

This kind of result is not an outlier, it is typical of the majority of investor behavior going back decades as reviewed in my book.

It seems investors never learn that short term returns alone are a very poor investment assessment measure as well as a very poor investment allocation tool. Make sure you are adopting “Best Investor” standards.

Conclusion

Investors need to be able to identify bubble conditions, and understand the longer term risk adjusted expected return of their strategies. This requires going well beyond only considering short term returns either as an investment assessment tool or as an investment selection tool. That has consistently led to tragic investment results. This experience shows up repeatably over decades and centuries.

Full Cycle Investing, allocating constantly to high expected return allocations can transform your results.

“Best Investor” Standards Safeguard Optimal Investing

In order to optimize opportunities safely, investors need to be set up with the most productive framework possible. Why not adopt the methodology of the most successful investors of all time? They all ended up embracing their own version of “Capital Preservation and Compounding”. You can find out why here.

The great additional advantage of “Capital Preservation and Compounding” is its clear definition. Just 5 metrics which can be illustrated in the Risk/Return Performance grid tell you in seconds how well you are doing.

Raise your accountability, transparency, understanding and control of your investing in real time by having access to this information.

Transform Your Investment Experience

The room for policy manoeuvre, and the stability of the current system should not be taken for granted. Volatility has increased and is likely to continue to stay high. The outlook has rarely been this uncertain.

Investment management needs Best Investor metrics and techniques as never before. Market and economic events require immediate action. If you need a quick review of the issues that you may need to know about for your own circumstances, schedule a FREE consultation today.

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Chris Belchamber is an IRMAA Certified Planner

Medicare’s IRMAA impacts every retirement plan. Learning how to mitigate it is available via IRMAA Certified Planners designation.

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