Control What You Can, Remove the Rest

Here are two schools of thought about the direction of the global economy and financial markets:

#1 – The Bear Case:

The case for declining equity markets is based on three historically sure-fire ingredients for a lasting bear market: rising interest rates caused by inflation, financial instability, and tightening credit. Even one or two of these factors has historically been a catalyst for economic and equity market weakness, so all three happening simultaneously is concerning.

While the growth rate of inflation has steadied, it remains stubbornly high despite substantial rate hikes thus far. Employment and wage growth remain strong, leaving little room for hope that price declines on key inputs are imminent. The Federal Reserve has made it clear that fighting inflation is its number one priority, and essentially the only tool at its disposal is interest rates, so rates will likely continue higher and remain that way for a long time.

Strike 1.

The financial sector has been in freefall in March, with the S&P 500 Financials Sector SPDR ETF (XLF) declining about 12% for the month, with a low of almost -15%. Emergency government meetings have convened to rescue multiple banks, while scores of others have endured runs on deposits and sharp stock price declines in recent weeks. Comparisons with the Financial Crisis have been common, as this has been the worst stretch of bank instability since 2008.

Strike 2.

With the public nervous about the banking system, what is the likely behavior from bank leaders? The answer is tightening credit. As scrutiny of bank balance sheets escalates, it is reasonable to assume that lending standards will stiffen until sentiment improves. Reduced access to capital impedes growth, which becomes another headwind for economic growth.

Strike 3 – you’re out.

#2 – The Bull Case:

But, markets are discounting machines. What do we mean by that?

The markets have historically been forward-looking. In the past, you’d hear a few stories of market participants who were able to identify an inefficiency, exploit it, and profit profoundly – but those were the exceptions, not the rule.

The advent of algorithmic trading and instantaneous execution has made profitably exploiting market inefficiencies even more difficult in the traditional sense. Changes in the market and market participants reacting to those changes are essentially happening simultaneously.

In general, if one is witnessing and reacting to a financial event, the assumption should be that the markets have already done so prior, and the opportunity is gone.

Why does this matter right now, and how does that make a case for a bull market?

The answer lies in market behavior since the last all-time high in U.S. stocks in December 2021. The markets spent 2022 pricing in the bear case presented above. High inflation, interest rate hikes, tightening credit, and a recession were progressively priced in with a few false rallies popping up when the hope of a soft landing ebbed and flowed. The pattern was lower high followed by a new low.

In 2023, U.S. markets broke this pattern and broadly formed a series of higher lows. Cost reductions and more sober revenue expectations pushed growth stocks to resume their leadership after experiencing a healthy retracement in 2022. Additionally, the speculative fervor in digital assets has been squashed, bringing some normalcy back to investor expectations.

The fact that material bank issues have done little to alter this pattern of higher lows is arguably the strongest bull case of all. Investors are largely seeing this for what it is – a few banks paying the price for reckless decisions. Sadly, these types of situations have always existed and will likely continue.

There’s a solid argument to make about markets having already priced in all the bear scenarios. With the worst seeming to be behind us in regard to inflation, rate hikes, and banking issues, the markets may be slowly weeding out the remaining bears. In the absence of selling, the markets naturally tend to climb. If we’re about to climb, you want to be on board or get on board.

The Conclusion:

It’s amazing how easy it was for us to articulate those two cases. Yet, as we conclude writing this Investment Update, we’re still conflicted about which case is more or less true.

The beauty of our systematic investing process is that we don’t have to predict:

• We didn’t know how good things would be in 2021, and it didn’t stop us from capitalizing on it.
• We didn’t know how bad things would be in 2022, and it didn’t stop us from being defensive for most of the year – especially as markets made new lows.
• We don’t know what remains in store in 2023, and it won’t stop us from continuing to follow our process.

Our trend-following systems will adapt like they always have. They’ll seek to put us in a strong position to avoid risk or seek opportunistic areas of strength, whichever is most appropriate for the market conditions ahead of us.

Having to chain yourself to one of the scenarios above, and hoping you’re right, is a scary place to be. Systematic investing removes the things you cannot control. What is left are factors that can work in your advantage. This is our belief and why we do what we do for our clients.