July 31, 2023
This seems like a perfect moment to educate our readers about the realities of market volatility. Today’s update will focus on this evergreen subject followed by a highlight of our Gain Keeper Variable Annuity strategy which is now breaking out to a new all-time high. I’ll finish with an important notice regarding our view of Macro – Economic changes happening now.
The Merciless Math of Losses
This is one of those timeless graphics that I keep in my lecture material for my high school financial literacy class. Not many people really understand the math behind portfolio losses and recovery percentages. For instance, why is it that Facebook lost -76% from the all-time highs in 2021 to the lows in 2022, is up +266% from those lows, but still sits -15% below the highs. How is that possible?
Simple math would say -76 + 266 = 190 right? Facebook should be trading way out at an all-time new high, right?
Well, no, because we are dealing with percentages and the loss of investment capital, not straight numbers. Let’s break it down to a simple example. Let’s say I give you $100, you go to Vegas, and you come home with $50. That is a 50% loss of capital. Now, how much of a percentage-based return does it take to get back to $100? 9 out of 10 people would quickly answer – You need to make 50% to get back to your break even of $100. Unfortunately, that is just bad math.
$50 + $X = $100
X = $50
$50 represents a 100% (not 50%) return on our remaining capital of $50. If we lose 50%, it takes a 100% return just to break even! Now consider the parabolic and merciless math of losses chart below.
It is sort of amazing to me how many companies with Billions, even Trillions of Market capitalization (value of all outstanding stock) lost more than 70% in 2022. Tesla (-73%), Meta/ Facebook (-76%), Netflix (-73%). Many of the Covid Unicorns lost 80-95% in 2022! Looking at the chart above, a 90% loss needs a 900% gain just to break even.
Best Practices for Managing Portfolio Volatility
We all make mistakes and experience losses with our investments. This is the nature of business. Trying to avoid losses altogether is not recommended. You will spend a crazy amount of time and effort doing so and discover that your performance is very poor over time. Smart investors understand this reality and work to control, respond or even capitalize on losses when they come. Most of the old guys (and gals) in this business will tell you to keep your losses small if possible and capitalize on volatility (aka losses) to your advantage. Here are some of the best practices.
- Harvest bigger losses for taxes and reinvest immediately.
This is a big one but only applicable to investments held at a loss in TAXABLE accounts. Let’s say we bought Peloton at the very height of the Covid scare in late 2020 and have subsequently watched the stock fall -94% to the current lows. Ouch! In a taxable account, a smart investor would sell the position and bank that capital loss as a credit against income (up to $3k/yr.) or offset future realized capital gains. Capital losses can be carried into future tax years indefinitely or until they are used up. The proceeds of that sell can and should then be reinvested in another speculative growth name of your choice in order to hold that space in your investment portfolio. It’s not wrong to own speculative stocks, just keep your allocation size small and appropriate for you! In a tax deferred account like an IRA, we are sort of stuck with the position and might wait 10-15 years for the stock to recover or move it to something with better prospects for sustained growth.
- Limit your Portfolio Volatility by maintaining diversification and appropriate asset allocations.
Hopefully we all know about this best practice, but rarely do I see it effectively maintained. One of the hardest things for investors is to take profits on a position that seems to just go up and up and up. Mega Cap technology names have sucked in so much investor money that the top 7 names represent over 40% of total market capitalization in the US stock market today. No one is selling because the experience of being overweight Mega Cap Tech has been so rewarding looking backwards. What I see today are way too many portfolios that have 40-60% allocated to Tesla, Amazon, Apple and Microsoft and the remainder in a mix of stock index funds that have the very same names in the top 10 holdings. This is not a diversified portfolio. What I regularly see are portfolios that are way out of balance and typically don’t own asset classes that have little or low correlation to their stock holdings. It is critically important that we work to maintain diversification and that means owning things that ZIG when other parts of our portfolio ZAG. You may or may not have noticed that bonds and stocks are now positively correlated since we entered the New Environment in 2020 (please read last week’s RSR). Now US Treasury bonds and US stocks ZIG and ZAG together in the same direction at the same time. No Bueno! Meanwhile Commodities are becoming a new and welcome source of true diversification – More on this in a minute. The point is we all need to weed and replant our investment garden periodically and make sure we don’t have too much or too little in our prescribed portfolio asset allocation holdings.
- Add to your investment portfolio at lows.
This one also seems obvious but so rarely followed as a best practice. We try, you know we try, to tell you when it is a good time to add to your investment portfolios. In the current market recovery, we have seen three great windows to do so in October of 2022, December of 2022 and again in March of 2023. When I look at volume figures for the market, I see nothing but quiet selling at these three intervals with very little net new buy side trades coming into the market. Now, the market is up 20-30% off the lows and the buy side volume is really picking up. In fact, in the last two weeks, we have seen some of the heaviest inflows into stocks in several years. Investors are buying high because there is a perception that risk is gone, recession is not going to happen, prices are going higher, and the Fed has whipped inflation. But, given earnings, interest rates, valuations and the new 5% risk free rate on money markets, even the most bullish of market analysts are saying the S&P 500 could go as high as 4700 by the end of the year. Today the S&P 500 is trading at 4566. So, we’re talking about maybe 2.9% higher from here? It is safe to say that there will be a better time to add to your portfolios than right now if one is looking for opportunities to buy low. Personally, I have found that any stock market environment trading more than 15% below the highs is a signal or trigger for me to identify new investment money and start looking for entry points to add to my investment portfolio. Today, the US stock market is roughly 5% below the all-time highs. The strategy of adding to your portfolio at deeper discounts works incredibly well but does take some guts and some discipline. Undisciplined investors sell at the lows and move to cash in fear. This is devastating to your portfolio and wealth accumulation over time and yet it happens time and time again.
Gain Keeper Annuity Within 2% of All Time New Highs
In the context of our discussion on managing volatility, I want to take a second to highlight our long-standing Gain Keeper variable annuity strategy at Nationwide. We run this investment strategy inside a variable annuity which offers investors unlimited tax deferral outside of a retirement account with after tax dollars (please inquire for more details). 2022 was a losing year for nearly all asset classes including US stocks down -19% and US treasury bonds down -16%. Our Gain Keeper annuity also had a negative return of -7.04% net of fees. 7% is a relatively easy loss to recover from (see above) and it won’t take more than a few more days for this strategy to nose out to a new all-time high. Gain Keeper attempts to remain fully invested but this is a strategy that can go where it needs to go in order to find true diversification, overweight opportunities and underweight obvious risk areas of the market. This is one of our longest standing dynamic asset allocation models that uses all of the methods described above as a means of limiting losses and capitalizing on market volatility. Today we are less than 50% in stocks and have recently sold down our bond allocation to build an overweight allocation to commodities and gold. A great investment strategy is built and run with great design and execution. Gain Keeper proves to be a strategy for All Seasons once again!
Change in Macro-Economic View
Admittedly, in March of 2023, it seemed fairly obvious to us that a recession, perhaps a very hard landing recession, was in the works and treasury bonds were offering a very attractive entry point. The Fed did their thing to curb inflation and successfully brought inflation back to the current 3% level – from 9% last June. Naturally, we would expect recession to follow such a move and we still believe that outcome is inevitable. Unfortunately, treasury bonds have gone nowhere and here’s the twist. By many measures, it appears that inflation is now bottoming again and even poised to push higher lead by commodities and other inputs. Oil is now back above $80! Copper just made an all time new high. Timber and agriculture commodities are making a run at the old highs again. And industrial metals are attracting some very large inflows from institutional investors. I found this article from Global X very compelling regarding the underinvestment and rapidly rising demand for metals at the center of the clean energy transition to electric vehicles. Please do take a few moments to understand this profound change in demand for raw materials that is happening regardless of our position in the economic cycle.
Additionally, Crescat Capital, who offers some of the best macro research out there, suggests we are now in the trough of the next wave HIGHER in inflation like that of the 70’s. That would be quite a shock to global stock markets that are just now ringing the inflation death bell and expect the Fed to start dropping rates soon.
We take our clues from the market leadership and it is noteworthy that commodities are one of the best performing asset classes since the end of June. Is this the next wave higher in a rally that began in 2020? Perhaps we should not be so quick to assume that short term interest rates will come down. Perhaps instead we might remain open to the possibility that long term interest rates RISE from here and eventually solve the inverted yield curve conundrum the hard way. Darwinize your portfolio!
Stocks can continue to do well if inflationary pressure and catalysts continue as they have been for over two years. Our job is to own those groups, styles and investment themes that have pricing power and continue to thrive and survive. Macro-econ is a dismal science, but it can help to set the stage for decisions we might make regarding our allocations and security selection. The markets are telling us a story that conflicts with investor expectations and the drumbeat of the financial media. These are important moments to watch and respond to what IS happening, not what we expect WILL happen. Stay tuned.
That’s it for this week.
Health and happy family reunions to all!
Sam Jones
