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Regular AAC (Asset Allocation Composite), SAA and TAA portfolios are always rebalanced on the first trading day of a month. the next re-balance will be on Thursday September 1, 2022. 

As a reminder to expert users: advanced portfolios are still re-balanced based on their original re-balance schedules and they are not the same as those used in Strategic and Tactical Asset Allocation (SAA and TAA) portfolios of a plan.

What We Can Learn From 1970s and 1980s

In May 9, 2022: The Secular Market Cycle Change, we discussed a possible secular trend change in financial markets (and economies). Specifically, it’s likely that we are leaving behind an era that has seen cheap money (ultra loose monetary and fiscal policies) and cheap labor (because of globalization), and are entering a period of high inflation and tight financial conditions. Since the last secular period of high inflation is between 1970s and early 80s, it might be a good idea to understand how major assets (stocks, bonds and real estates) had behaved in that period. 

Stocks, bonds and home prices in 70s and 80s

Let’s first take a look at the history of Consumer Price Index (CPI) that tracks inflation: 

Note that annual CPI change started to climb in late 60s and it then went through a couple of ups and downs, first reached a high of 12.2% in November 1974 and the finally reached 14.6% in March 1980 before it started to come down. The latest steep rise of CPI is somewhat similar to 1974 and we will shortly discuss the similarities and differences in a later section. For now, we can clearly see that inflation has broken out of the range from 1982 to 2022, a 40 year or so period that has seen cheap labor, low interest rates and loose financial conditions. 

We mentioned that stocks actually underperformed bonds in this period in our previous newsletter, but few know that S&P 500 total returns underperformed commodities prices such as the Producer Price Index (PPI) in that period. Here is a chart that compares S&P 500 with PPI (data are from 

So to some extent, one can claim that stocks lost purchase power from 1970 to 1986, a very long period!

Similarly, if one were to invest in a total return bond index (such as Vanguard total return bond index fund BND or VBMFX) in that period, it also lost purchase power with respect to inflation for quite some time: until 1985 or so. But compared with stocks, it fared a little bit better.

In the above, we assumed both the starting CPI index value and the ICE BofA US Corporate Index Total Return Index value as 100 in December 1972. We can see that the corporate bond index (total return, i.e. including dividend reinvested) only started to outperform CPI in mid 1985. 

Now let’s take a look at real estate prices vs. CPI in the US. It again was barely able to keep up with CPI: 

In the above, it compares Case-Shiller Home Price Index with CPI. 

Unfortunately, if we indeed enter a period similar to 70s to 80s, it’s not promising for major assets to keep up with inflation. Or put it bluntly, be prepared for a possible loss of standard of living in the coming years. 

Similarities and differences from 70s and 80s

Well, one can argue that the current condition is not the same as that glooming period. First, let’s look at the similarities:

  • High inflation: by now, this is very obvious. But will high inflation persist for a long period of time? No one can answer this question for sure. But from what we showed in the above chart, it’s possible that inflation rate will persist for a while and then come down (look at 1974) and then rise again. As companies have started to bring back their manufacturing onshore, it’s bound to incur higher labor cost. Given the current structural geopolitical structure in the world, we are afraid this will last quite some years for sure. The odds of high inflation in the coming years are very high.
  • Stop and go monetary tightening: as the moment, we are seeing a Federal Reserve bank that at least claims to do whatever it takes to tame inflation. However, because of political (election, for example) and economic pressure (recession fear), the Fed is very much constrained and likely will get into a few of alternating tightening and then loosening phases, similar to 1970s. The steep CPI rise from 1974 to 1980 was mainly caused by the Fed’s interest rate cut (a premature one) in the end of 1974. Currently, we are seeing a possible hint for the Fed to become dovish, as evident in the last week’s FOMC interest rate press conference (see, for example, this El-Erian’s interview).
  • A low unemployment rate or a tight labor market: unemployment rate in 1968 and 1969 had stayed very low: 3.4% to 3.9%, similar to today’s 3.6%:

Unfortunately, today, we have some more unfavorable and more serious problems: 

  • Today, major asset prices are way more elevated. Stock wise, for example, Shiller PE ratio for S&P 500 was only at 20 or so before 1970, compared with today’s 28.7% (that already came down from the recent high of 40):

  • Similarly, unlike high interest rates or Federal Funds Effective Rates before 1970 (8.97% in December 1969), today’s 1.68% is ultra low: 

  • Total government public debt over GDP ratio: today is 136% compared with 35% in 1970 (see, again, this website for more details). 
  • On the other hand, we do have a Federal Reserve bank that’s been more experienced (at least has hopefully learned some lessons from the past). 

To summarize, the longer term picture is not rosy and investors should start to adapt their long (40 years or so) investment framework and be well prepared for this new cycle. For us, we believe it’s important to adopt a risk managed tactical strategy to manage one’s overall asset allocation (among stocks and bonds) as well as fixed income (bond) investments. 

Market Overview

Let’s now turn our attention back to current conditions. The US has just had two consecutive quarters of negative GDP growth (the second quarter GDP growth is -0.9%) and it’s technically in an economic recession. Officially, for many plausible reasons such as a  (still) healthy/tight labor market and an expanding industrial production etc., it hasn’t been declared as such. 

The ‘good’ news is that stocks and bonds rose sharply last week, especially after investors sensed (or guessed) a possible loosening stance from the Federal Reserve’s interest rate policy: basically investors interpreted that with a slowing economy and a peaking inflation, the Fed is now likely to pivot or become less aggressive to fight against inflation. However, if history is of any guide, even if inflation is peaking, it might be just temporary, just like in 1974, and it might become way much harder to tame it down if the Fed starts to become less aggressive and later on inflation rises again. 

Earnings wise, Factset reported a better than expected earnings growth for last quarter: by last Friday, with 56% S&P 500 companies reporting actual results, the blended earnings growth for Q2 2022 is 6%, better than 4% expected. However, Deutsche Bank AG’s chief strategist Binky Chadha argued that things are not as good as they seem in the following:

Earnings growth is strong at the headline level but is down sharply below the surface. On a year-on-year basis, S&P 500 earnings are on track to rise by a robust 9.4% in aggregate. However, there are three unusually large items in the quarter to consider in gauging underlying trends in earnings, two positive and one negative, but which together are providing a big boost to headline earnings in Q2: the massive increase in Energy earnings (+10.5 percentage point boost to S&P 500 growth); the return to profitability for the pandemic-impacted companies (+2pp); and the drag from banks provisioning for loan losses (-4pp). Excluding the impact of these three items, underlying earnings growth for the rest of the S&P 500 is only at a modest 1.2% year-on-year. 

Basically, excluding energy companies, earnings in S&P 500 companies have grown very little. 

It’s clear that if the Federal Reserve continues to raise interest rates, it’ll weaken (it might already happened) the economy enough for it to eventually go into a recession. Earnings in this case will come down dramatically, On the other hand, if the Federal Reserve starts to pivot or loosen up, it’s possible to boost asset prices in the short term (to what extent is anyone’s guess). But it’s likely to create an even higher inflation later on. Both are not good for risk assets such as stocks. 

We again call for patience and ask investors to stay the course. Our strategies will respond to market and economic conditions as it goes:

  • For strategic allocation (buy and hold) investors, ignore the current market behavior. Remember, as what we have emphasized numerous times, when you choose and commit to a strategic portfolio, you essentially know and commit that your investment horizon (or the time you need to utilize this capital) is 20 years or preferably much longer given the current high valuation. As we pointed out, if your investments are those diversified (index) funds such as an S&P 500 index fund (VFINX, for example), you know your money is in some solid ‘business’ that eventually (20 years later and preferably many more years later) will deliver some reasonable returns. As long as you are comfortable with this thesis, you should sit tight and forget about the current gyration.
  • For tactical investors, again, you have to ignore the current market noise. Furthermore, you should follow your strategy rigorously, especially in a time like this. Human emotion, both optimistic and pessimistic, and human desire, both greedy and fearful, are your worst enemies. This has been shown to be true time and time again.

Stock valuation has dropped. However, it is still high by historical standard. For the moment, we believe it’s prudent to be extra cautious. However how serious a correction might be, we have confidence in the US economy in the long term and thus in the stocks in aggregate. We just need to manage through interim losses carefully.  

We again would like to emphasize that for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.

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