Monthly Outlook: February 2022
Markets are off to a very soggy start in 2022. The S&P500 is off 5.3%, the NASDAQ is down 8.7%, and even bonds lost 2.1%. Why? For the past two years, markets have been rallying in a stimulus bubble, created by the Federal Reserve (Fed) and Congress, who collectively pumped an extra $6 trillion into the markets. Last month, the Fed told us that they would steadily take away their monetary stimulus and Congress hasn’t passed any bills to provide additional stimulative programs. Those two factors were enough to make addicted markets shudder in withdrawal.
For a while now, we’ve noted that stock markets have been over-valued, trading at 100-year high valuation metrics. We’ve also consistently noted that valuations are a very good predictor of 10-year subsequent returns but are not good at predicting short-term returns. Momentum or “trend” is what drives short-term returns. And for the past two years, we’ve had to ignore increasingly high valuations and ride the uptrends. Like traveling with kids on a road trip who ask, “Are we there yet?”, we’ve been driving over-valued stock markets waiting for the uptrend to break. That finally happened in January and it’s the first time in two years. So yes, we’re finally “there” and our trend-following signals required us to sell.
The Trend Changed in January
For the past two years, stock markets have trended higher. Every five percent dip was bought, and the momentum continued. Like many investors, we consider the 200-day moving average to be a good definition of “trend” for our holdings. As long as a holding remains above its 200-day moving average, or trendline, it’s best to hold it for growth. Conversely, when a holding dips below its trendline, it’s best to sell it and raise cash for protection. Consider this: every bear market starts with a cross below the trendline. But not every cross below the trendline turns out to be a major bear market. It’s also true that you cannot have a raging bull market below the trendline. In January (on different days), every major stock market changed from uptrend to downtrend. That’s right, every one: US Growth, US Value, US Small, INTL Growth, INTL Value, and Emerging. Value is doing a little better than Growth, but they’ve all turned down. The only sensible thing to do, and what we have already done, is sell the downtrending holdings, raise cash, and move to protection mode.
What to Expect in Downtrends
So, stock markets rolled over to downtrends in January. While that is concerning to us, we remain level-headed and calm. Bull markets (like we’ve just had) do not give up easily and we expect strong counter-trend rallies along the way. Some markets may even flip-flop a time or two between down and up-trends, and we should expect that. It’s also possible that a few of the markets return to an uptrend while others continue in a downtrend. But as of today, all stock markets have entered a downtrend and it’s right to be underweighted. Rather than locking in to a bullish or bearish outlook, we’re committed to investing with the trend. Our trend-following strategy requires us to keep your assets fully invested in each uptrending market and very under-invested the downtrending markets.
Main Street vs. Wall Street
Ironically, it’s the strength on Main Street that is causing the new downtrends for Wall Street. The Main Street economy is recovering very well from the COVID pandemic despite the supply and demand imbalances it created. A stronger economy is demanding more goods and services than the available supply can provide. This imbalance has created inflation in goods, services, and labor costs. And that’s the problem for Wall Street. The Fed really has no choice but to do its job and reduce stimulus to squelch inflation. The Fed will continue to tighten monetary policy until inflation is tamed. How long will that take and how high will interest rates go? That’s the big question on Wall Street, today. It will take months to answer that question and it will depend on ongoing economic data. That data will likely be mixed, but the recent sell off in stocks suggests that investors are increasingly concerned. The new January downtrends in stock markets reflect those concerns and are our signals to invest cautiously for now.