May Day {Current Client Letter}

 “As full of spirit as the month of May, and as gorgeous as the sun in Midsummer”William Shakespeare .”

 

May Day 2023.

 

I’m began composing this note to you on May 1^st.In many European cultures this day marks the beginning of summer.It’s an ancient custom and is often celebrated with bonfires, maypoles and flowers.Early May’s a good time to take stock of where we are so far in 2023.My last letter to you was in January.Then the markets had just completed one of their worst years in history and the mood was about as bearish as I’ve ever seen.Few WallStreet investment strategists were positive back then for 2023.I didn’t agree with an outlook that had many calling for a retest of October’s lows. I was decidedly non-consensus when I wrote this to you then:

 

I still think investors have discounted most of 2023’s negative economic news.Probability suggests equity prices are still attractive for longer-term investors.I don’t think we’ll see asignificant economic downturn this year. I also think we’re further through this tightening cycle than most investors appreciate.I think this because many of the leading term inflation gauges are already showing this.Housing prices quit going up months ago.Construction has slowed significantly.Gasoline’s back to where it was over a year ago in most places.Supply constraints from Covid have eased while the era of Federal stimulus related to the virus is fast becoming a thing of the past.Historically when stocks have experienced significant declines, then one-, three- and five-year rates of return are uniformly and significantly better than the historical market’s annual return averages.

 

Here's what’s happened since.A recession has failed to materialize so far this year.If it comes, I believe it is unlikely to be as steep or severe as many feared back when there was snow on the ground. The Federal Reserve has kept tightening interest rates but has now indicated they might take a pause on future increases, preferring now to wait and see if they’ve done the devil’s work and put enough of a break on the economy to get inflation under control.Supply chain constraints are now a thing of past.The national average price of gasoline, while recently on the rise, is still 10% lower than a year ago and is trading at price levels seen between 2012 and 2014.Earnings estimates have not contracted as deeply as analysts believed last fall and may have already seen their trough for this cycle. First quarter 2023 earnings are currently ahead of most analysts’ expectations.Major market indices bottomed out last October; many stocks actually made their lows last June.Markets are considerably higher four plus months into 2023, collectively averaging about a 6% return.The Nasdaq is up nearly 17% in these first four months.Still, investor sentiment remains lousy as many call this a false dawn and still believe we could retest last fall’s lows. Time to get out the crystal ball and see where we might be going.

 

Here's the positives.The economy looks like it’s weathering this slowdown as of now.Markets are always looking towards the future and investors seem to have already discounted the worst back in 2022.Investors are already looking out twelve to eighteen months from now and are indicating they believe the economy will be improving by then.Corporate earnings should also be on the mend later this year.Then there’s investment history which says when stocks start off the year this strongly, there’s a higher probability of further advances down the road.Finally, we’re in year three of the current Presidential election cycle and the theory around this states that years three and four of a President’s term tend to be positive for stocks.

 

Now the other side of that coin.The market is the ultimate arbitrator of price and future events could change this analysis.The stalemated war in Ukraine could take a turn for the worse and the Chinese could become more belligerent towards Taiwan.It is always possible we’re on the cusp of a worse recession than I believe may occur.Perhaps the Federal Reserve won’t like what it sees in the economic tea leaves and continue raising interest rates.They may not like data like Friday’s stronger than expected job gains.Some or all of these events might occur, however, every one of these issues are now well known to investors, and I believe are likely currently discounted in the markets.We’ll monitor these events and adjust portfolios accordingly as needed.

 

Markets usually spend most of their time trading slightly below or slightly above what is deemed theircurrent fair value in terms of price.I get excited when I see assets trading at a significant discount to this numer as they seemingly were for much of 2022. I grow more conservative the closer we get to what I perceive my investments for clients are worth. Probability suggests there's a higher likelihood that we’re currently skating along the upper edges of that valuation zone.That doesn’t mean markets can’t move higher, and there’s a greater possibility of higher prices occurring in a year when stocks roar out of the gate as strongly as they have in 2023.However, probability also suggests we may need to spend some time now consolidating our recent gains.Markets correct themselves by price {meaning they decline in value}, time or a bit of both.We corrected by price in the first half of 2022 and now seem to be correcting by time.To that last point, equity markets are currently trading where they were last April.I’ll bet that statistic will surprise a few people.A period where markets churn back in forth and mainly go nowhere could be in the cards for the next few months.We could perhaps even retrace some of this year’s gains.That would also sync with the investment calendar.This tells us the next six months or so have historically been the weakest part of the year for share prices.Market indices have also now on average retraced about 50% of last year’s losses so traders could be tempted to lock in some of those gains.I do not see this as a long-term fundamental problem unless the international news becomes more pessimistic or the economic data starts to become worse than many currently believe. I view it more like the pause that refreshes before we potentially begin another move higher.

 

Now would be a good time for us to discuss your asset allocation if you’re worried about any of this, or there’s been a change in your circumstances. We’ve deployed most of client’s excess cash positions into Government money market accounts this year.These are currently earning about 4.5%.That seem like a nice place to hide until bargains appear.We did most of our buying months ago when equities were cheap and have largely been rewarded for that patience.

 

I like our investment portfolios and am happy to go over your accounts anytime you desire.

 

Very truly yours,

Still At Sea

 

USS Arizona {BB-39} departed Naval Station Pearl Harbor 0806 hours Hawaii time December 7, 1941. Sill listed at sea by the United States Navy.

Fall Market Comments

I promised at the end of August that I would be back in touch sometime this fall.  This is my third attempt at writing this note. Events have moved so rapidly these past few months, that I’ve constantly been tearing up what I’ve already written and starting over!  Finally, I think there’s enough clarity to update you on the markets and my thinking going into 2023.   Stocks had rallied off their summer lows at the time of my last letter.  However, I warned then of the possibility of further weakness in the coming months.   Sure enough, markets fell an additional 8% through mid-October on inflationary concerns, higher interest rate hikes from the Federal Reserve and fears of a slowing economy as a result.  Markets seem to have found their footing around June’s price lows.  Even so, the average stock is currently trading about 18% lower than it was at the end of 2021.  Many individual securities have experienced declines significantly higher than that.   This will obviously affect the performance of Exchange Traded Funds as they are a basket of equities, comprising an index.  However, given the shake out we’ve experienced this year and given the current economic climate, I believe there is a higher probability of better investment conditions going forward.  This letter will explain why I think that and my thoughts regarding investing in this environment.   

I’ve previously written of the similarities between our current investment environment and what America experienced immediately after World War II.  The US economy of the late 1940s struggled as businesses needed to convert from a military to a civilian economy almost overnight.  Then as now the country experienced supply chain bottlenecks and inflation.  The reasons for this were that wartime price controls ended and people had money because there’d been little to spend it on during the war.  The results were soaring consumer demand which stoked an inflationary shock.   Inflation between 1946-48 topped 10% per year.  Markets struggled in that environment.  Eventually these issues were resolved, the economy began to grow again and equities began an advance that lasted until the 1960’s.   Similarly, we’re still dealing with the aftershocks of the economic disruptions caused by Covid.  The world economy’s been rocked by high inflation and shortages.  This stems largely from the supply chain mess, pent up demand and unprecedented levels of worldwide economic stimulus resulting from the virus. The war in Ukraine has magnified many of these problems.  

Our government’s response to inflationary pressures has been to significantly tighten credit and the money supply.  Both inflation and rising interest rates, plus the fear of an economy slowing more than the Federal Reserve would like to see has been a significant headwind for both stocks and bonds this year.  Cash has been one of the few places for investors to hide.  Even bonds have failed to perform their traditional stabilizing function in more conservative portfolios.  2022 through October is the 2^nd worst performance year so far for a traditional measure of a balanced investment portfolio where 60% is invested in equities while the other 40% is placed in fixed income.  That data goes back to the 1930s so you can see how rising rates have hurt even more conservative approaches to investing.    

 

That being said, I’m increasingly of the belief that much of this bad news has been discounted by investors.  Like earlier in the year, probability suggests equity prices are in a price zone where value’s being created in the markets, though the rally of the last week has likely taken some of the shine off of that assessment.   There’s a higher probability the economy will slow in 2023, but avoid a long-lasting and perhaps more significant downturn.  I think this is possible because our methods of measuring the economy, which largely go back to when we were more of a manufacturing nation, underreports our real growth.   While I believe interest rates will continue to rise going forward, there’s now a higher probability that future rate increases will slow and potentially be finished by the end of 2023.  This too I believe is largely discounted in stocks.  Besides, interest rates are high only relative to the investment environment we’ve seen since 2008. I spent the first twenty plus years in this business with rates higher than today and equities were able to advance then in the face of that headwind.  I believe now will be no different.  
   

Finally, we’re seeing evidence suggesting inflation is starting to subside and the supply chain issues that have bedeviled the economy are slowly straightening themselves out.  We also seeing declines in used car prices, construction, and home purchasing.   Add into that that when stocks have experienced significant declines such as we’ve seen this year, then historically one-, three- and five-year rates of return are almost uniformly higher and usually significantly better than the historical averages.  Another positive is it’s looking highly probable that the House of Representatives has flipped over to the Republicans.  This isn’t a political comment but a note that investors prefer divided government as it provides a guard against overzealous political tinkering with the economy by the Executive Branch.   Finally, stocks have also flipped over into the best six month seasonal period in terms of performance.   

My current strategy is no different than what I suggested was appropriate for long-term investors when the weather was warmer.  I am of the mind to strategically purchase ETFs where I can find value on market declines, depending on client mandates, cash levels and risk tolerance.   I am highly confident in the portfolio of ETFs that I hold in client accounts and still believe equities are compelling for those with a 12–18-month time horizon.  Similar to last summer, I still believe this is a period where money can be added to accounts if one is so inclined.  Nobody will ever know the exact date the market bottoms. However, probability suggests a higher degree of certainty for profit at these levels for those with a long-term investment horizon.  Also, since the investments we make for clients are only in Exchange Traded Funds, our risks are not necessarily tied to any individual stock’s performance within the indices these investments represent.  Finally, in taxable accounts I am employing tax loss harvesting strategies to minimize both current capital gains and to lower cost basis.  In the long-term investment equation what you keep is almost as important as what you make. Nobody likes losses, but these can sometimes be used in ways that potentially benefit a portfolio longer-term if implemented correctly by lowering the tax bill to Uncle Sam.
   

Finally a realistic note about war in the Ukraine.  Investors are discounting continued losses for the Russians and a likely settlement to the conflict at some point.  This assumption flies out the window if the war takes an unexpected twist, particularly if the Russians utilize a nuclear weapon or device.  Should that occur, then I’ll warn you that markets worldwide will likely have at least one, and possibly a series of very bad days.  Unfortunately, short of having all cash, there’s no realistic way to mitigate this risk in a manner that most investors are willing to assume.  This is similar to a natural disaster like an earthquake.  It may be occurring now as I’m writing this letter, or tomorrow or never in any of our investment lives.  I think the nuclear option is a very low probability. I would hope there are enough rational people in the Russian chain of command that would recognize the utter catastrophe of such an event and resist the order.  I also think the current direction of the war means the likelihood of this continues to decline.  However, while the odds are low, they are not zero and I think all of us should be aware of that risk.  I am happy to discuss this with  

you if you would like.  
   

I am still optimistic we’ll see higher stock prices over the coming 12-18 months.  Price action since October tells me that other investors also believe equity valuations are more attractive, although perhaps not as attractive as a week or so ago.  Information may change and we may not have seen the ultimate lows in stocks for this cycle, but probability suggests we’re close.  Further declines from here would only increase this argument.  Stocks may also take longer to recover than our last bear market from Covid in March of 2020.  But probability suggests that time and price are likely now on our side.

Ave Elizabeth, Regina Angliae Dei Gratia

 

The young Lady that went up a tree house in Kenya a Princess so many years ago and came down a Queen has gone to her final rest.  The Queen was brought up with a sense of obligation and duty that is a relic of a bygone era.  It feels dated and out of touch by modern standards to many.  Yet she upheld her view of that to her very end.  It must have made her father and mother very proud when she presented Herself to them yesterday.  A toast to a life well-lived.  God bless and Godspeed.

In Pace Dormit, Elizabeth, Regina Angliae A Multis Dilecta!  

An End of Summer Market Update

 An End of Summer Market Update. 

I thought I’d give a very brief update on where I believe things currently stand with the markets.  I said in my May email letter and in my July investment letter that I thought stocks had become over sold.  I based that on fundamental economic facts, valuation, and proprietary money flow analysis data that I monitor.  Well, from their lows in Mid-June until mid-August major market indices rallied nearly 17%, erasing about half of this year’s losses.  My guess is we rallied a few weeks ago to what is probably current fair value for the markets based on the economic and external data.  Since then, equities have struggled.  That’s partly because of the economic data, partly that we’re in the middle of summer, partly because Wall Street is on vacation and partly because that same data suggesting then we were over sold in June had entered an overbought phase in August.  We’ve now given back about 6% of this summer’s rally. 

This being the week of the Labor Day long weekend, markets will be in vacation mode until the holiday passes next Monday.  There is a higher probability of volatile and listless trading until then.  What happens next will largely be dependent on the upcoming economic data, news on the inflation front and other the headlines, such as the war in Ukraine.  Probability suggests equities could be volatile and range bound between now and sometime closer to the elections.  Probability also suggests that markets will be more prone to rally when they understand which party’s going to be in charge of the House and Senate come 2023.  Wall Street would very much like divided government, meaning one of those two branches flips into control of the Republicans.  Currently, it looks like there’s better odds of that happening in the House than the Senate. 

For reference points of the range in which I think stocks will trade until we get some clarity on the elections and maybe inflation, I would use this summer’s market bottom in June {currently about 8% lower and index levels from about ten days ago {also about 8% higher} from today’s prices.  That means we’re more or less stuck in "no man’s land" as far as valuation is concerned, hence the volatility and chop we’re currently experiencing.  This is a great environment for traders and frustrating for investors.  Of course, events could change this analysis but that’s where I think we stand as of this writing.  I will use weakness to strategically make purchases of ETFs I find attractive given what I think 2023 is shaping up to look like.  

Remember, markets discount future economic growth and so, as hard as it is to believe, the investment world is already looking out six to eighteen months from now.  That means investors are turning their gaze to 2023 and even early 2024!  Assuming we get runaway inflation under control, then the economic picture looks brighter out there than perhaps it does today.  Probability suggests that given what we currently know of things that markets are perhaps 10-12% undervalued looking out that far.  Of course, I’m prepared to change that analysis if the facts change, but that’s what I see as the last vestiges of summer slowly slip by. 

I’ll be back in touch sometime in early fall to update you on my thinking then.  Until then enjoy summer’s last waltz.  Seems like only yesterday we were welcoming in the sun for Memorial Day.  Time flies. 

Summer Letter 2022

 There’s been no place for investors to hide in 2022 as the bear market that actually began in late 2021 has seen stocks tumble.  The S&P 500 lost nearly 21% in the first six months of this year.  The NASDAQ as well as the average growth-oriented investment index was down nearly 30%.  The average stock lost nearly 24% of its value in the first six month of 2022. It is the worst first half performance for stocks since 1970 and is the worst ever performance for a more balanced portfolio as bonds have been in their own bear market since the Federal Reserve signaled last winter that they were going to start raising interest rates.  I’ve previously covered why this has happened, so I don’t think it’s worth wasting the ink on that.  Instead, I’m going to discuss how I’m thinking about this and what we might see going forward.  First though I want to address the longer-term picture.  

 

Markets and investment cycles don’t operate on our seasonal calendar of day’s weeks, months and years. Markets will rise and fall based on investor’s gauge of future economic growth.  Thus, while seasonal characteristics and investor sentiment play an important role in the daily movement of stock prices these will be trumped by investors longer views about the state of the economy.  Right now, the many longer-term positives in our economy, are being trumped by inflation concerns as well as the corresponding rise in interest rates and the war in Ukraine.  Data is emerging that inflation may be peaking, but investors worry about a slowing economy and are sitting on their hands.

However, stocks are long duration assets and their returns should be measured over longer time periods.  Here then are some numbers to keep in mind.  From its lows in March 2009 through the end of June this year, the S&P 500 is up 462% without dividends.  The Nasdaq Composite, an index of growth-oriented investment names, is up 771%, again without dividends.  By our work each of these indices has seen ten corrective periods equal to or greater than 10% during this period.  The Covid related crash in March of 2020 lopped 35% off both indices in about six weeks, yet each of these indices was still considerably higher at their lowest levels in 2020 than their 2009 market lows.  Both the S&P 500 and the NASDAQ are still up better than 60% from those Covid lows even after this year’s decline.  Let’s think about that.  Given everything that’s happened since the beginning of 2020, after all the pandemic trauma and economic dislocation, after all the rioting and violence stocks are still higher than in March of 2020.  Even given the largest war fought on European soil since 1945, ruinous inflationary numbers and after a hard decline since last fall, stocks are still offering a return that’s likely better than anyplace else most investors could have put their money since the 2020 market lows.  You could lop another 20% off the market averages and this would still likely be true.  Each correction at their worst felt like the end of the world and the investment punditry came out each time proclaiming the end of the bull market.  They were wrong then and I believe they will be wrong again for reasons I’ve discussed with you many times in the past few years.

Mankind has yet to invent an investment that is riskless. Volatility-the decline in market prices or their daily price gyrations is the ticket you punch when you invest in equities.  It is the markets’ reset mechanism. Investors should expect some volatility and should accept that sometimes prices will correct.  Equities are never a one-way ticket higher.    Volatility, while most often associated with declines, can work both ways. Presumably though, investors don’t mind when there are sharp gains in their investments. Investors mostly hate volatility as prices head lower. There are strategies in our playbook that deal with more volatile periods that we use in our game plan for client accounts. One of the easiest methods is to have some cash on hand.  However, since it is unlikely that your portfolios will ever be 100% in cash when invested with me this is not complete protection against declines.  Put it this way, if Warren Buffett knows of no way to completely hedge a portfolio, then it is probably impossible to do.  The goal when investing is to be aware when the markets are in a lower probability environment, and have enough cash that fits into your risk/reward parameters.  Hopefully you will be able to deploy that cash as markets begin their next advance. 

In a period like this, we must recognize how things have changed and then adapt that change to portfolios.  I have been using this period to reorganize portfolios as necessary while selectively adding to positions that I believe are attractive, given my usual 12–18-month investment horizon. I believe the current environment is well suited towards my ETF process.  This is especially true where I believe investors have likely priced in much of the bad news and mounting evidence that inflation is peaking.   In the short-term this may not play out but I believe there is value being created in this current decline as long as the economy continues to grow.  I am always attracted to ETFs where the current market dislocation has brought the fund down to levels where the dividend is attractive.   Dividends can provide some support in market declines.  Markets will rise and fall in value, but the cash earned from dividends is yours to keep.

There are also enormous advantages to ETFs, especially during volatile times.  However, ETFs are not immune from market declines.  They will also lose value by something that mirrors the decline in the underlying index when the bear growls.  However, we can invest knowing we own a diversified portfolio of assets, backed by the value of the securities in an underlying index while removing single stock risk from the portfolio.  The history of equities tells us they can be wracked by fraud, can trade to zero due to a catastrophic loss or be rendered obsolete by unforeseen technological change.  But it is an extremely low probability event that a plain vanilla ETF, especially one with a long trading history and based on a well-established index, will suffer such a catastrophic event causing it to lose all its value.  I say this is a low probability event because 36 years of investing has taught me there are no guarantees.  However, the inherent value of the underlying assets and the unique creation and redemption process of ETFs make this unlikely.  Frankly it’s likely the only events that would cause the majority of ETFs to trade to zero would be ones where we think most of us would have more things on our minds then the value of our investment portfolios.  Because the underlying assets supporting ETFs have value, we can use our systematic approach to creating portfolios and strategies from this asset class.

I believe much of the bad news has now likely been priced into stocks.  I also think investors will need some time to rebuild trust and that it will take longer for us to recover from this decline than 2020’s Covid related rout.  Declines like what we’ve recently experienced usually take time to heal.  Probability suggests it could take anywhere from six months to a year for stocks to approach our most recent highs.  These would be nice returns going forward if I’m correct. However, I’ll also warn you of the possibility we haven’t seen the final lows for this bear market cycle.  That would just make equities more compelling in my opinion.  Here’s why.  Historically declines of this nature tend to be excellent places for long-term investors to find value.  This decline ranks as the 11^th worst six months period using the Wilshire 5000 Index.  Near-term results can be mixed but going out a year shows the average return is 26%, the average three-year return is 56%, the average five-year return is 115% and the average ten-year return is 281%.  That is why I’ve suggested that if you have extra cash lying around, now might be a good time to let me start dribbling it in the market for you as long as you can stomach some short-term volatility.   

Irrespective of the near-term, I am unchanged in my optimism about the future, the economy and the markets.  The reason I’m so positive has to do with the pace of technological advancement, which is still increasing exponentially and is unlikely to slow down in the foreseeable future.  I’ll invite you to go back and read on my blog, lumencapital.blogspot.com, what I’ve said before on this subject. Just know that many of these previously discussed trends are advancing more rapidly than ever.Behind these ideas are new businesses, jobs, and economic advancement. But markets are never a one-way ticket higher and corrections will happen.  Even our previous bull market had periods where it paused to catch its breath. Then as now there were also periods where stocks did not advance.  I think we’ll review this period in the coming years as one of these pauses.

Fortunae rota volvitur or Fortune’s wheel is always turning.  It always looks the worst near bottoms and while perhaps we’re not completely there yet, the resounding negativity and the weight of the evidence suggests we might be close.  Commentators who have constantly called for the end of the world have been wrong and have cost both themselves and others many opportunities over the years.  To that end I will again leave you with comments from Warren Buffett about stocks and volatility.  They are as relevant today as when they were first uttered.

 

“The unconventional, but inescapable, conclusion to be drawn from the past fifty years is that it has been far safer to invest in a diversified collection of American businesses than to invest in securities — Treasuries, for example — whose values have been tied to American currency. That was also true in the preceding half-century, a period including the Great Depression and two world wars. Investors should heed this history. To one degree or another it is almost certain to be repeated during the next century.

Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskierinvestments — far riskier investments — than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.”

*Long ETFs related to the S&P 500 and NASDAQ in personal and client accounts.

Christopher R. English is the President and founder of Lumen Capital Management, LLC.-a Registered Investment Advisor regulated by the State of Illinois. A copy of our ADV Part II is available upon request. We manage portfolios for investors and also manage a private investment partnership. The information contained here is taken from sources deemed reliable but cannot be guaranteed. Mr. English may, from time to time, write about stocks or other assets in which he or other family members has an investment. In such cases appropriate discloser is made. Lumen Capital Management, LLC provides investment advice or recommendations only for its clients. As such the information contained herein is designed solely for the clients or contacts of Lumen Capital Management, LLC and is not meant to be considered general investment advice.  Mr. English may be reached at Lumencapital@hotmail.com.