Quarter Two Market Recap & a Deep Dive on Current Market Conditions
In the wide array of clients that I have the privilege of working with, I find that some want as little information as possible about their investments while others want to peel apart my brain layer by layer to know exactly how I see the current market conditions. In an attempt to appeal to as many different learning styles as possible I am going to start implementing an “overview” header on all market updates where I will do my best to summarize the newsletter in one (run-on) paragraph so that those who want just the highlights can get all they need to know in under 60 seconds. And for those that want more information, beneath the overview I will be going into greater detail about current market conditions and the factors that go into our market assessments.
Overview
The first half of this year has been brutal for markets. Huge sell offs, rising interest rates, soaring inflation, and a looming recession etc. The good news, we were in a conservative position, so Lane Cuthbert Financial client portfolios were immune to the losses. I believe we’ve seen a temporary bottom to the selling as media has caused a peak in investor fears (among some other factors), so we’ve adjusted portfolios to take an aggressive position for the remainder of the year to catch some gains.
Deeper Dive
Let start by looking at the current market picture:
As you can see, the first half of 2022 has been marred by extreme selling and declining prices in the market. In fact, the selloff is worse than what was seen during the COVID drop. It’s a bit deceiving but this 2022 decline has been a drop of about -23%,
and while the COVID drop measured -33%
it appears in numbers that the COVID drop was worse but that’s because the percentages are measured against the market’s value. Since the market rallied so aggressively over the past 2 years, it appears like this selloff isn’t as bad as the last one, however, if we measure the two selloffs side by side you can see that this recent drop in the market has exceeded the COVID fall.
So, what’s the significance of going into this great of detail trying to measure these 2 selloffs? Well, this is the foundation to the deciding factors that has helped support the decision we’ve made to take a more aggressive stance in portfolios.
One of the factors that we considered is that after the COVID selloff, the market rallied almost +73% to finish out the year +15.5%.
Since we had client portfolios in a conservative position, Lane Cuthbert Financial clients were immune to the market selloffs and felt only a small portion of declines in 2022 relative to the markets selling which means that by expecting a strong market rally for the remainder of the year we have very little lost ground to make up which should translate to strong portfolio returns for clients. Conservatively, if the S&P500 rallied so that the annual return for 2022 was 0%, that would be roughly a +30% rally from the current market location.
The next major factor that we considered is the measure of fear in the market. This is a picture of the VIX which is commonly referred to as the “fear index”. The higher the price on the VIX, the higher the fear is among investors.
Historically the VIX has a few major “resistance” prices, meaning that when the price of the VIX hits either $35ish or $50ish it has a major reversal in price and the market rallies.
Now if you look closely at that picture, you can see that at all the arrows the price of the VIX quickly touches those resistance prices in a single touch and then falls away quickly causing a sharp reversal in fear and the market rallies.
This is where things get a little interesting. If we zoom in on the past 6 months, you can see that the VIX has touched the $35ish mark every single month for the past 7 months in a row.
This doesn’t feel that ground-breaking considering every single social media outlet and news headline seems to be spouting out new scarier headlines every day! If we consider this from an order flow perspective however, it reveals a lot more than you’d think.
Remember that the stock market is a zero-sum game, so when someone is buying another person is selling and vice versa when someone is selling then someone else is buying. Since banks and institutions are the largest players in the game with the deepest pockets, it can be said they place the largest buy and sell orders in the market and in order for them to get their entire desired position filled they have to have all other market participants on the opposite side of their trade. By keeping fear at a high level for an extended period of time, the psychological toll that has been taken on retail investors has set in and begun to change their mindset about the market.
The rally cry of all retail investors last year was “BUY THE DIP!” as they were treated to exceptional market rallies after every little pull back in the indexes. But now in 2022, every single month for 7 months in a row, every dip in the market has led to further selling and every market rally has been short and bittersweet as a new low of selling for the year is created. Retail investors are scared of the future due to headlines about rising interest rates, looming recession, soaring inflation and they’ve now been conditioned that every market rally is met with more selling. So, if retail investors fear a worse future and are selling to stop further losses then who’s buying from them? It’s not other scared retail investors…it’s banks and institutions because for them to get their entire desired position filled, they need to herd everyone else onto the other side of their trade.
The last time the market saw multiple price touches at one of these key resistance price levels was in 2007 prior to the 2008 financial crisis.
This acts as a further confirmation that we believe will lead to a strong second half to the year…after that, we’ll likely need to protect ourselves from the downside risk again but we’ll cross that bridge when the time comes.
The last consideration we looked at was interest rates. This might seem redundant for those of you who have heard me discuss interest rates before but for those who have not let me briefly discuss the purpose of interest rates. Interest rates, being controlled by the Federal Banks (Fed Reserve and Bank of Canada in North America), are designed to be used as a market controlling tool. The idea being that when the economy is strong, the Federal banks should be raising rates to take advantage of the strong economy, collect higher interest on the money they’ve lent out during a time when the work is good and profits are comfortable, and most importantly cool off the market to stop a “bubble” from forming. And it works the other way as well, when the economy is suffering, they lower rates which stimulates economic activity by encouraging people to buy a home (since the monthly cost is reduced, or buyers qualify for higher borrowing amounts) or borrow money to invest in their own business or start a new business which results in the economy being spurred on once more and decrease the chances of a recession from occurring in the market.
Now that you understand interest rates it’s easier to understand the issue we’ve run into, which is that the Fed Reserve and the Bank of Canada have pinned themselves into a corner. Look at this:
This is a graph that follows the US Fed Funds Rate. In 2009, as part of the quantitative easing program to help recovery after the financial crisis of 08’, central banks cut rates to 0.25% and the economy recovered…but then they didn’t raised rates for 6 years. Over that 6-year period the market rallied 216.5%!! In that strong economic environment, the Fed’s failed to raise rates which meant they lost their ability to use interest rates as a tool to stimulate the economy if another downturn was to occur. And while they did raise rates from 2016-2019, it was less than half of the pre-financial crisis interest rate levels and left rates at historic lows, so when COVID hit they didn’t really have anywhere to go but back to 0.25%.
The issue with next to 0% interest rates is that it (coupled with easy access to money) leads to increased inflation rates. Which is exactly what the numbers showed as inflation rates soared to almost 10% and levels not seen in 30-40 years. That leaves the Fed Reserve with two choices to lower inflation rates. The first is to reduce their balance sheet through quantitative tightening (stop printing money) and the second is to raise interest rates. While we haven’t seen them use their common sense in reducing the rate at which they print money, the central banks have chosen to take an aggressive stance to fight inflation by increasing interest rates in leaps and bounds.
Notice the stair stepping pattern from 2016-2019. Those are sustainable achievable, DIGESTIBLE interest rate increases because every small increase allows the general public to adjust their budget as the cost of their loans and borrowed money increases (think variable rate mortgages). Now look at how steep the rate increase curve has been since the beginning of 2022. Crazy sharp! Like almost 90 degrees! This crazy adjustment has been harsh to the people, but I believe it has been for a strategic purpose. Anyone in any sort of variable rate loan situation has seen a big increase in their monthly cost of borrowing which begs the question: is variable rate or fixed rate mortgage better?
For many years the variable rate mortgage has benefited anyone who’s taken advantage of it but now with all the headlines talking about the increase in fear for further interest rate hikes to curb the “out of control inflation” situation, it leaves a lot of homeowners thinking that locking into a fixed rate mortgage would be best to protect themselves against further interest rate hikes. We call the difference between the fixed rate mortgage cost and the variable rate mortgage cost the fixed/variable spread. Pre-COVID the fixed/variable spread was tight with the fixed rate having only slightly higher rates. If we look at the fixed/variable spread today, it’s a huge chasm with fixed rates being much higher than variable rates.
I personally believe that this has been the plan all along. You see, during the pandemic home prices rose like CRAZY (I don’t need to tell you, you live in Vancouver). Many homeowners stretched themselves to get into properties that were soaring in cost and that worked alright since the monthly cost for the properties was affordable at interest rates of 0.25%, but now that rates have increased to pre-pandemic levels, a RECORD number of homeowners have now transitioned into fixed rate mortgages vs variable rate mortgages. Homeowners are locking in higher monthly payments to protect themselves against the possibility of future rate hikes, but since the fixed/variable spread is so huge right now banks are collecting a humongous pay day and have resurrected their fat cash cow. Every month, homeowners are making massive payments on a record amount of debt at historically high interest rates and now banks are stuck in a real awkward spot.
Single detached home values have seen a decrease of 25-30% since the beginning of the year and the start of the increase in interest rates. Let’s use a $2,000,000 home as an example. Say that a family stretched themselves to purchase this house. In BC, the required minimum down payment on a $2,000,000 home would be $275,000 (not including realtor fees and closing costs). If this family put down the minimum down payment, they would be looking at a mortgage of $1,725,000. When your home is worth $2mil and mortgage is $1.725mil that’s ok, but home prices have decreased, so potentially this home isn’t worth $2mil anymore, say it’s only worth $1,700,000.
With the increase in interest rates, late-comer homeowners are right on the verge of being “underwater” on their mortgage, that is, the value of their mortgage is worth more than their home. Maybe they’re thinking “we don’t care because we plan on being in this home ‘long-term’ so the value will come back before we sell.” And they would be right to think that, however, the last time that we saw homeowners go underwater on their mortgages was back in the financial crisis of 2008. What started out as being only slightly underwater turned out to be severely underwater, and what might only be a few over-levered or multi-property owners selling their home (or worse, foreclosing/defaulting) quickly turns into a tidal wave of homeowners selling. Even though people plan on staying in their home long-term at some point (when homes have lost enough value) homeowners are left asking themselves: “why would I continue to pay a $1,725,000 million dollar mortgage when my home is only worth $1,000,000?”
This scenario puts the central banks in an awkward spot. They’ve been raising rates to fight inflation but in doing so they’ve put a large portion of the population on the ropes by pushing them to the cliff edge of burying people underwater on their largest financial asset. If Fed’s continue to raise rates they run the risk of toppling the first domino and repeating a global financial crisis and a housing crash. This leads me to believe that the central banks are close to parking interest rates where they are (at least until the public has a chance to digest the rising cost and/or pay their mortgage down some more). Since they were able to create a large spread between their fixed/variable mortgages, they’re happily going to collect big pay days from homeowners concerned about higher rates when the reality is they can’t raise rates any further without dire, global, consequences.
If you’ve read this far, kudos. I hope that these insights have been valuable for you and shed some light on current market conditions without all the noise of news headlines. If you’ve been working with me for any length of time you’ve likely heard me refer to our investing method as a sailboat. When the conditions are right, we put out more of the sail to capture greater gains and returns, and when conditions aren’t right (to protect capital) we make sure that we don’t have too much sail out to avoid breaking the mast.
In May 2022, we finally…after a few long years, opened up the sails from an ultra-conservative position to a very aggressive position.
We did this for a few reasons. As mentioned above, but also because we were in an ultra-conservative position, our portfolios were immune to the isolated market sell-offs. What I mean is, while the index averages have sold off, they haven’t sold off as much as the individual underlying assets. Let me give you an example. In the Nasdaq 100, there are a group of stocks referred to as the FAANGS, that is, Facebook, Apple, Amazon, Netflix, Google, Starbucks. This group is often associated together since they are listed on both the S&P500 as some of the largest companies (and therefore have the most impact on the market) and also listed on the Nasdaq as being tech sector companies (also having a large impact on that market). While the Nasdaq saw a decline of -32% the FAANGS saw declines of -54, -40, -27, -73, -29, -41 respectively. The largest companies that have the greatest impact on the indexes fell significantly further than the index averages. So while the market might appear that is still has room to the downside, the underlying assets have already seen their major sell-offs.
Since the portfolios that we invest in, are invested in these companies we were able to avoid the market sell off and severe declines of these individual companies. And since we want to be buying low and selling high, the indexes might not look like they’ve sold off as much as their parts, but beneath the surface these companies are price levels not seen since the early 2000’s and so for that reason we’re making an aggressive adjustment to get on the same side of the trades as the banks and institutions to continue looking for low risk, high probability, profitable trading opportunities. This usually requires us to go against our human nature. To be greedy when others are fearful, and fearful when others are greedy. It’s going to be a great close to the year!
I thank you for your continued support and look forward to another opportunity to serve you, and your family’s wealth accumulation goals.
If you would like to book an appointment to review your personal portfolio or discuss your portfolio in more detail, please send an email to Lane@LaneCuthbert.com to schedule a time.