Complexity and Lots of Questions

By Michael Kayes, CFA Charterholder

My quest to read 100 books in 2022 reached 66, when I finished perhaps the preeminent biography of George S. Patton, written by Ladislas Farago. The book was extremely long at 832 pages, but it had to be to do justice to the multi-faceted and complex life of one of the most famous generals of the Second World War. I imagine anyone that has seen the movie “Patton” will remember his opening speech to the troops. “Americans love a winner and will not tolerate a loser.”

There is a complexity even to that statement. I wonder if Americans are still inspired or even comfortable with those words today…

Our country continues to struggle in multiple ways. Not surprisingly, it has been a very difficult year in the stock market so far. Given we have recently reached bear-market territory, it seems appropriate to discuss how bear markets bottom. So, let me try to do that.

How do bear markets bottom?…What are the leading indicators that the inevitable recovery is about to begin? Are you thinking at this very moment that given all the worrisome issues impacting the stock market today, that perhaps a recovery isn’t inevitable, enough questions.

Equity markets bottom in various ways. The first way is by duration. Stock prices can go sideways for an extended period while the negative news runs its course, so to speak. Whether it is economic, geopolitical, or some exogenous shock that has caused a bear market, eventually all the news gets discounted and has progressively less impact. During this process, stock prices can go sideways, building a new base as market technicians would say. One indication that a sideways market is basing is when additional negative news no longer drives stock prices lower. This phenomenon can affect individual stocks and/or the market as a whole.

The second way an equity market can bottom is by price. Virtually every stock is a buy at some price level. Even if the economic fundamentals haven’t improved, stocks can bottom when the price declines too far, driven by excessive fear instead of disciplined fundamental analysis. Fear, being the most powerful human emotion, can play a significant role in leading to a market bottom.

A third way an equity market can bottom is by a dramatic, unanticipated development, which serves as a catalyst, changing the sentiment. In essence, alleviating the worst-case fears. In hindsight these catalysts will be obvious, but they aren’t when they happen, almost by definition.

So, how will the 2022 bear market bottom?…I think it is going to take more time. The worrisome issues need to be worked out before the next bull market can begin. Keep in mind, the previous bull market lasted nearly 13 years (2009 – 2021). During that period, the annualized return for the S&P 500 was 16.0%. This is significantly above the long-term average which is closer to 10% (Source: 2022 SBBI Yearbook). My sense is the next several years will produce annualized returns closer to the long-term average, if not below.

What are the worrisome issues facing the market today?… The first is inflation. How long will it persist at the current rate of 8% +? Over what time frame will it decline and to what level? Economists at the Fed and on Wall Street have been wrong on inflation. Pressure is mounting on a politicized Fed to do something. Can they bring inflation down without putting the economy into a recession? Those questions need to be answered before the market can bottom.

The second is the political direction of our country. Will the progressive agenda of wealth redistribution and ever-expanding entitlements continue to forge ahead? If so, what impact will that have on the entrepreneurial and productive components of our economy? Will businesses refrain from taking risks, turn insular and hoard cash, thereby depressing future innovation and business development? It might be useful to contemplate these questions, in a global context. The U.S. has several strategic advantages over the rest of the world, including Europe and China. Compared to Europe we have the demographic advantage of a younger population, faster economic growth, driven by an entrepreneurial spirit and free-market capitalism. We have the same advantages compared to China. In addition, we have the rule of law and intellectual property protection, which isn’t the case in China. Moreover, we have vast natural resources that China lacks.

Despite the market drop this year, the demand for U.S. financial assets remains very strong, due to these competitive advantages. We have to keep these advantages. Every one of them is important to the long-term potential of the economy and financial markets. The progressive agenda is diametrically opposed to the long-term success of the markets. There is no other way to state it.

At a foundational level, America seems to be redefining what winning really means. I suspect we will have to come to some consensus about that before we can actually achieve it. Will it be characterized by global leadership, or will it center around some concept of nationalism? Will it be inclusive or exclusive? And, as always, who will lead us to victory?

Patton believed in reincarnation. He also swore profusely yet read the bible every day. Would he be an effective leader today? What do you think?

Michael Kayes, CFA

Sources:

2022 SBBI Yearbook – U.S. Capital Markets Performance by Asset Class 1926-2021 Kroll, LLC New York, NY

Exencial Wealth Advisors is an SEC-registered investment adviser. Any references to the terms “registered investment adviser” or “registered,” do not imply that Exencial or any person associated with Exencial has achieved a certain level of skill or training.

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