The Exchanges

Q Let's talk a little bit more about market volatility and specifically inflation. Obviously you alluded to it before, you know, sharing how some of the intervention from the fed appears to be having an impact on inflation, but from the retail investors perspective, What are the asset classes or investment vehicles that are best suited for an inflationary environment or an environment where there is more market volatility?

A Yes, and it's interesting, you know, that last year, obviously, stocks were down, bonds were down in price, but usually, when you have volatility, um, episodes, let's call it that, the bond market is the port in the storm, and that's the side of the market that acts very calm, while the equity side, the more volatile side, is acting up, and last year, the bond market was really the center of the storm, right? That was the eye of the storm, because yields were, had been so low, During the 20, 20, 21 sort of COVID, you know, lockdown days, and so that's where the reset came from. So when we think about the markets now, the good news is that valuations have reset quite nicely, and especially on the, on the bond side, right? You can buy a ten-year Treasury now for about 4.2% inflation expectations per the, what we call the TIPS market, the Treasury Inflation Protected Bond Market, Where you can buy treasuries, but priced in real yield terms. If you subtract the real yield of tips from the nominal yield of regular treasuries, you get an implied inflation rate, and that inflation rate is around two and a quarter, two and a half percent, uh, which is the market's way of saying that the Fed will be successful in taming inflation. And remember, the CPI has already gone from nine percent last year, June, To now three percent. So we have seen significant improvements, even though the core…

AI assessment note: “especially on the, on the bond side, right? You can buy a ten-year Treasury”

Q Totally. And so, given the context of, let's call it a softer landing or a no landing at all that we're sitting in right now, how would you describe what the key factors are that are driving the investing landscape at this very moment?

A So, ultimately, the markets come down to earnings, Interest rates. That sets valuation. Uh, it comes down to sentiment, and clearly going into the year, you know, since our last episode, the market was sort of on the wrong foot, right? I think that generally people were positioned defensively, expecting that earnings shoe to drop, and the earnings shoe has not dropped. You know, first quarter earnings season actually came in pretty good, and the second quarter has come in pretty good as well. So, Second quarter earnings season just wrapped up. 80% beating estimates by an average of seven percentage points. It's pretty good. Now, overall earnings are declining very, very modestly. They're, they're scheduled, uh, estimated to be down three percent this year, which isn't very much. So when I say that 80% are beating by a certain percent, it just means that earnings growth ended up being less bad than was expected. So This has been the year of resilience, really, in the economy, and if you think about it, right, 70% of the American economy is consumer spending. Consumers are spending, right? People are spending money because they have jobs. Unemployment is very low, and wages are, now that inflation has come down, it's still elevated, but it's a lot less elevated than it was, and now wages are starting to keep up with inflation better. So People have money in their pockets. They ha…

AI assessment note: “ultimately, the markets come down to earnings, Interest rates. That sets valuation.”

Q was, and they'll hear what this does is it takes away purchasing power from the money that they have in the bank, and they get concerned of, are they going to be able to live in the same way? What are strategies that they should be employing given where inflation is? How would you be thinking about this if you were A retail investor that you were providing guidance to?

A Yeah, so one thing to remember is that stocks, equities, historically have been a good hedge against inflation, right? Stock prices follow earnings. Earnings are measured in nominal terms, right? Because if a company sells more stuff, it's measured in price and volume, and so the stock market, generally speaking, not always, but generally speaking, has been a good inflation hedge. So Your compounding returns over time and those returns in nominal terms, generally, historically speaking, have been above the inflation rate, right? So if you go way back in time and you look at the average compound annual growth rate for the S&P. 500, it's about 10, 11% in nominal terms. That doesn't mean that that's what you get every year, but that's over the long term, like a 50 year, 20 year period. And in real terms, it's about six and a half percent. So that's over and above the inflation rate. And again, a lot of it comes down to whether the market is correct in expecting inflation to be under control going forward at about two and a half percent. And remember, as I mentioned before, the CPI has already gone from nine back down to three. So three is pretty close to what the TIPS market has been saying. I think the, the lifting will be a little heavier going forward because what we call the base effects, you know, that rate of change calculation where you add in the current month and you drop…

AI assessment note: “stocks, equities, historically have been a good hedge against inflation”

Q we've spoken about inflation and how inflation has changed over the last nine months. We've talked about the feds policies around rates and how rates have moved over this period of time. We've talked about earnings and kind of like the modest change in earnings we've seen from companies relative to what the market anticipated. What are other current market trends that investors should be paying attention to right now?

A Well, as I mentioned, you know, earnings, interest rates, valuation, sentiment for the stock market, I think, are the four sort of pillars, if you will, and I would say the most noteworthy thing to mention that's happened between when we last talked in November to now is that the market has priced in a very specific scenario. It has priced in a soft landing, and We don't know if that soft landing is going to materialize. It has so far, right? I think this year, certainly the economy has been firmer than most people expected, and you see this if you look at economists' growth projections for GDP. At the beginning of the year, the economies were expecting basically no growth for the year. Now they're expecting close to two percent real growth, so clearly those expectations have been reset, and the market has, you know, probably correctly Basically pivoted to that scenario, but the market has priced it in, right? So the market always discounts the future, and so the PE ratio for the S&P has gone from 15 to 20. That's a pretty big move. That's an almost 30% move in the market, and so now this soft landing has to continue to materialize, or the markets might be sort of on the wrong foot. So I think that really becomes the main issue, I think, for the next Six to 12 months is will the scenario that the market has already priced in now come to fruition? And if it does, the market can …

AI assessment note: “the most noteworthy thing... is that the market has priced in a very specific scenario. It has priced in a soft landing”

Q And while, you know, anything can happen, it seems like the odds of a recession are lower or full blown recession and something closer to a soft landing is much more likely. But I told you I wanted to revisit the concept of a recession for investors. So the million dollar question is, As a retail investor, how should I be thinking about investing into a recession? Should one happen?

A That's a great question, and it's one that I've fielded many, many times in recent months, and people ask, you know, give me, give me a recession portfolio. What is, how, how do we invest recession proof? And the problem is that recessions are, you know, we know the yield curve is very inverted, and it has been inverted for a long time, so short-term rates are well above long-term rates, and they've been that way for almost a year. And we know historically that that yield curve signal has been very accurate in terms of forecasting a recession. So by that measure, we should get a recession maybe in 2024. The problem is that the lead times between the inversion of the curve and the eventual recession is all over the place. It can be as little as six months. It can be as long as two years. It doesn't really tell you how severe the recession will be. How long it lasts, and so my answer is always, you know, in order to trade the recession playbook, uh, you have to market time, and I can tell you, I've been in the business almost four decades, and I, I can't do it, like, you know, and I have all the resources, you know, at my disposal to try to do it, and it's just a really tough game, because you need to know four things in order to trade around a recession. You need to know when it starts, you You need to know how long it lasts, how bad it's going to be, and even if you know all of…

AI assessment note: “in order to trade the recession playbook, uh, you have to market time”

Q and how investors should be thinking about it and positioning themselves for it, but I want to talk about the other side of the inflation coin first, which is rates. Rates haven't been this high since I was eight years old. I don't know what grade I was in, but it was 22 years ago. How do you see this impacting current and future investments with where rates currently stand?

A Five and a quarter to five and a half, so the Fed thinks of it as a range of a quarter point. And a year and a half ago, the Fed was at zero, zero to a quarter. So it is one of the fastest, most aggressive rate hiking cycles that we've ever seen. And, you know, it was for good reason, of course, and that was the inflation that came out of the reopening following the pandemic, and there were other reasons for it as well. And the way we think about it is, again, in real terms, right? So If the Fed is at five and a quarter to five and a half, and the expectations are that the Fed is either done raising rates or getting very close to being done, and you take that TIPS break even, and again, the TIPS market doesn't have to be correct necessarily, but that's the collective wisdom, if you will, of the financial markets, um, and, and that wisdom or that collective opinion is saying that inflation will be around two and a half percent for the coming five years or so, So you subtract two and a half from five and a quarter to five and a half, you get real rates of plus three. That is about where the Fed generally goes in terms of a hiking cycle, right? So the full cycle tends to be five, six percentage points from two to three below what we would consider a neutral rate, which is generally thought of as about three and a half percent or so, to about two to three percentage points above. S…

AI assessment note: “the way we think about it is, again, in real terms”