Ukraine: The Horror
Those close to the tragic war in Ukraine are coping with unprecedented amounts of sadness, anxiety, and uncertainty. Capital markets have been quite sympathetic, with European issues rising +8% during the week before selling off after reports of stalled peace talks. Investors are looking for solace and are positioning for a crisis.
My heart goes out to those suffering, and I encourage everyone to donate or offer support if possible. I encourage full divestment from Russia and Russian-linked assets. Iโve moved my EM exposure away from Russia and China, and toward Latin America. The $ILF ETF is the easiest way to access Latin America.
The ruble has plummeted further, but Putinโs approval rating has actually gone up during the Ukraine invasion. It last went from 62.5% to 88% following the Crimean invasion.
Russian markets have fallen to pieces as Western sanctions hit and Putin attempts to pull off a โfortress economyโ. Look up โautarkyโ sometime to see how well this idea has worked in the past. (Hint: It doesnโt really work.) With an ongoing currency crisis, and Russian equities/rates imploding, people are getting worried. The S&Pโs profit exposure to Russia is only 0.1%, fortunately.
Fears of sanctions have weighed heavily on equity markets. It seems as though most fears are priced in, but gross deleveraging seems to be persisting. Fear not; this too shall pass.
Worthy of note this week is Ukraineโs trading partners, of which China is the largest.
A look at CPI data is enough to make me flinch. This is what Iโd call heavy inflation numbers. Besides being invested in value, thereโs not much for investors to do besides wait it out, stick to their guns, and beat inflation in the long-run. Doing so in the short-term is likely impossible.
CPI will be a pain point for years to come, I imagine, and a real problem for domestic politics. As Iโve mentioned before, equities have beaten inflation over every 30-year period going back centuries. No matter how sticky this inflation is, itโs important to keep yourself invested. At least the dividends should remain relatively unscathed, and buyback programs should ramp up.
Quick reminder: If you enjoy my work, please consider dropping a tip. Times are unfortunately tight for me right now. Thanks! Keep reading for lots and lots more!
Russian Sanctions and Commodity Export Bans
Fears over a lack of Russian oil supplies have roiled markets, giving us some of the highest energy prices in recent memory. If we adjust for inflation, weโre still a ways off from prior peaks, however. I donโt expect prices to remain this high in the long-term, and expect WTI crude to level out around $70 in the longer term.
Prices at the pump have started becoming scary, hitting $6 at some pumps in California, with many blaming Joe Biden. If only Joe Biden could fix the price of gas, Iโm thinking this would all be an awful lot easier!
The US has a highly subsidized system for energy, and the effects of high energy prices will be felt beyond the pump, whether itโs through supply chains, airfare, or simply just taxpayer funded subsidies for Exxon et. al.
Commodity prices have already surged due to Western sanctions over the war in Ukraine.
President Putinโs order goes into effect immediately but he did not state which goods and raw materials will be affected by the restrictions, according to Business Insider.
Russian President Vladimir Putin has signed an order banning and restricting some exports and imports.
Russia is a major exporter of commodities including oil, gas, wheat, and metals.
Commodity prices have already surged due to Western sanctions over the war in Ukraine.
The order includes a ban or restrictions on "exports outside of the Russian Federation's territory and (or) imports to the Russian Federation's territory of products and (or) raw materials," according to an Interfax news agency translation of the order released on Tuesday.
The document said the ban goes into effect immediately but did not state which goods and raw materials will be affected by the restrictions. The Kremlin has ordered the government to compile a list of foreign countries that will be subject to the restrictions, Interfax added.
Itโs probably wise to remember that this isnโt Russiaโs first rodeo. Russia has always been an expansionist nation. I was recently reminded of a famous map of the Soviet Union from the 1960โs, presented here in ultra high-resolution for those whoโd like to read the text or take a closer look.
If not, just realize the USSR was truly enormous, and their influence was far more global than it is today.
A look back at post-WWII Soviet Russia gives us a glimpse of what Putinโs territorial ambitions may be. Without the backing of the US/UK, itโs begun to look like Europe would fall rather quickly in a hot war, which is a frightening thought. I always wondered why the US had 50,000+ troops in Germany (and has for as long as Iโve been alive).
One can simply compare Asia/US and Eastern Europe to Western Europeโฆ Iโm thinking that spending priorities will change. More nuclear, more hard defense, more cybersecurity. More troops. Especially in Western Europe.
I think itโs safe to say that weโll see quite a bit more defense spending in the coming years, regardless of what happens. This goes for cybersecurity as well, with companies like $CRWD and $NET warranting another look in light of exigent and expected future circumstances.
BofA had this to say regarding the Russian invasion:
Elevated Inflation
CPI came in hot in February, with inflation hitting necessities hard, particularly food, energy, and shelter. Headline CPI rose 0.8% in February while core CPI rose 0.5%
Itโs important to look at things in historical context. Hereโs all the CPI data I have available, broken down into table format and color-coded. I love pink! But I do not like inflationโฆ Anyway, hereโs sixty years of inflation data:
We can see the incredibly high inflation rates of the 1970โs, and many investors are girding for a similar situation.
The past 5 years of inflation have remained relatively flat until surging through 2021 and into 2022. The Fed is currently in a very tricky situation, as tightening now could set off a recession.
With the market faltering amid inflation and supply concerns, thereโs a lot to consider for the Fed. Here are four charts that help show why the Fed is going to have some issues:
In short, itโs been a rough year so far, and asset deflation has hit us at the same time as inflation in real assets. Itโs difficult to justify all of the inflation weโre seeing. While some of it will remain sticky, other parts of the market are raising prices โjust becauseโ, as we heard during several earnings calls.
Consumer staples are engaging in coordinated price hikes, for example. All of this is contributing heavily to inflation numbers, and is certainly not helping matters on the CPI or rates fronts.
Headline inflation forecasts, weaker consumption and global growth, along with uncertainty about Russia/Ukraine are cutting 2022 growth forecasts by 0.3%-pt to 2.4% (4Q).
Expectations for rate hikes have softened. The Fed can be expected to hike rates by 25 basis points. I doubt they will raise them 50 basis points, as has been discussed. Even 75bps has been discussed. Rates liftoff has always been tricky to predict.
Most predictions are wrong. Get used to it. ๐
Economic Conditions
Domestically, economic conditions are worsening. Retail sales figures on Wednesday should tell us more, but expect a drop of 0.1%. Chase consumer card data seems to indicate as much.
Card data doesnโt look particularly strong, with some moderation in spending as consumers are tightening belts.
Trying to fine-tune macroeconomic views with such volatile geopolitics is certainly a challenge. Credit channels have remained relatively unharmed, and commodities appear to be the primary channel of transmission to inflation and growth. News of the US closing off energy imports from Russia were met by the European Commission proposing sharp cutbacks in natural gas imports from the region, risking a larger shock.
Brent crude should remain near $110/bbl. European natural gas prices should stick around โฌ120/MHw during 2022.
Higher energy and food prices should generate a further inflation shock. Incoming readings for February show a significant spike in prices that may be intensifying, with global CPI inflation expected to hit a multi-decade high. 1H22 global CPI inflation should hit 7.1%ar.
The Drawdown
First, we need to remember that this is a midterm election year (MTE). During MTE years, weโve seen average drawdowns of -17.1% from January through October, with significant rises during the following 12-month period from October through October.
(I believe these charts are based on data from 1984-2018, possibly 2014.)
To help put the recent #SPX drawdown into perspective, Iโd say that investors are overly focused on media headlines, and trying to react to each move. Instead, Iโd recommend keeping your eyes on the prize (or on the price).
Technically Speakingโฆ
#SPX 4200 is an โarea of interestโ, as the correction from early January carries on, but without true capitaluation (based on NYSE 90% up and down days as well as the ARMS). Until we see otherwise, this should result in increased churn in US equities. The market doesnโt seem to want to break below this level.
Iโm not a technical analyst, but one would tell you that if 4200 is โbreachedโ or โbrokenโ, then we could expect a further fall in equity valuations.
A correction could become an actual bear market or recession. I think this is a possibility, maybe 15-20% if I had to put a number on it. That said, Iโd hate to be in cash when the market lifts off. (Just missing Wednesday really did a lot of damage to people who werenโt in the market, and I noticed a lot of reactionary flows into US equity mutual funds the following day. Those investors only lost money.)
Corrections in secular bull markets tend to be less severe, but they also tend to last longer. Finding an asset allocation you can live with through the ups and downs is the only evidence/fact-based approach for this situation. Thereโs no secret trick, and thereโs no way to time it.
The 3-month VIX relative to the VIX stands alone as a tactical sentiment indicator that has signalled capitulation. However, three probes to contrarian bullish oversold levels below 1.0 on the 3-month VIX/VIX since late February have shown very little in terms of positive market responses, which could be considered risky.
For those watching moving averages and key levels, you may find this chart useful:
We Need a Break
The market and world affairs are awfully stressful. So, letโs take a look at Elon Muskโs Twitter habits over the past 10 years.
What a beautiful visual! Interesting too. He hasnโt been tweeting about SpaceX predominantly since long before the run-up in Tesla shares. Does it mean anything? Probably not, but whoever made this infographic is amazing.
Speaking of people who really need to be taxed more, we had a fun look at the tax-to-GDP ratio of nations around the world. The visual could be improved, as it uses surface area rather than diameter to show proportionality.
In short, Denmark has the highest ratio at 46.3% and the US is next to Ireland, Turkey, Chile, Mexico, and Colombia. Most developed nations have tax-to-GDP rates between 32 and 46%
The future of employment (or the future of automation, depending on your perspective) is something thatโs always interested me. While itโs not exactly uplifting, itโs a fascinating visual to go over.
Retail salespeople/cashiers and counter workers would get hit the hardest, along with shipping/receiving, traffic clerks, bus drivers, and salespeople. Receptionists and grounds maintenance, accountants, auditors, bookkeepers, and miscellaneous assemblers/fabricators would all be hit heavily.
On the finance front, Wealth101 provided some excellent data about the power of compounding over time. I shared a visual guide on the power of compounding earlier, too. Itโs good to think about the future, sometimes. Hereโs the guide, split into four images:
Truly fascinating. I wish Iโd been able to start saving at an earlier age, but it just wasnโt possible in my family.
A Look At SMidcaps
February was a great month for quants, with factor-investing being net alpha-generative: 90% of the long factors outperformed an equal-weighted R2K benchmark. This is a 34-year record, thatโs stood since 1988!
In a note to clients, BofA stated that 70% of the funds in the SMidcap universe outperformed their benchmarks in February. Itโs incredibly rare for active management to beat benchmarks for very long, but this kind of market has been quite good for many actively managed funds
Value has continued to outperform. BofA noted: โFree Cash Flow Yield and FCF/EV were also among the top Value factorsโ, which is exactly what youโve been hearing from me. $COWZ is one of my favorite investments.
While I donโt agree with these suggestions, thereโs a couple good ideas. Iโve been short $FFIV most of the year, although I just went flat (cybersecurity/nationalism concerns from Russiaโs invasion made me decide to flatten). Hereโs what BofA is telling private clients to buy for SMidcap tech:
Itโs a difficult place to be investing now, but going by FCF/EV is something I am a big proponent of, and am surprised itโs not a more popular factor. That said, I would be worried about investing in many of these companies. Iโd want a bit more time. Some of these may be good buys for younger investors (age 20-30), but thatโs just my opinion, and I could be wrong.
Of more use was BofAโs small cap factor chartboard, where they say theyโre favoring late-cycle quality assets.
Long/short factors in late cycle (these involve shorting low quality and going long high quality, and may not represent something truly investable. The hit rates are noteworthy, however.)
Saving the best for last, the factor performance from small-caps (as of 2/28/22) for Quintile 1 and Quintile 1 less Quintile 5. In short, they sort stocks by factor exposure into 5 quintiles. This lets us quantify the robustness of factor performance by measuring it against itself. For example, high volume stocks like Apple would be in Quintile 1 for a liquidity factor screen, whereas less-traded issues (the ones with big bid/ask spreads) would be in Quintile 5.
Vanguard even has a โliquidity factorโ fund that targets this factor. (The idea is that liquidity can be a factor in outperformance, with less-traded issues seeing higher future returns. Active managers avoid low-liquidity stocks which can distort price discovery. This is a less-researched factor.)
In summary: Long/short factor baskets are pretty common. The issues with the highest factor exposure are put in the 1st quintile, where issues with the lowest or negative factor exposure are in the 5th quintile. Itโs a little tricky, but it helps capture factor performance in volatile markets more easily.
Letโs take a look at the 3-month chart.
If youโre a SMidcap investor, Iโd encourage weighing these two charts against each other. I simply use $AVUV and $VSIAX for long-term exposure to small caps, and I currently like $COWZ and $VSEQX for mid-cap exposure. $VOE and $VBR are perfectly acceptable alternatives, although $IJS may be better for small-caps if, for some reason, you donโt like Avantis or $AVUV, which is their most liquid ETF. (Remember, Vanguardโs small-cap indices are a bit higher on the cap spectrum than most other providers, as they use the CRSP 6-10 index rather than the S&P 600 or Russel 2000.)
I Canโt Tell You โBUY VALUE NOW!โ
I wish I could. But I can certainly keep posting charts about it. Zooming out to a 1-year view, the factor performance is very clear. Value is the top-performing factor group for small and mid-caps, through multiple time frames. I think the rotation is more than clear now.
Itโs the same for large caps, but thatโs for another day.
I posted my whole portfolio on Twitter earlier, as I will be doing some rebalancing, but feel free to take a look if you need any ideas.
I recommend using Morningstar to do your research on mutual funds. Currently, my top holdings include $SPY, $VWNDX, $VTV, $DODGX, $AVLV, $COWZ, $AVUV, $VBR, $VWICX, $FNDF, $VTRIX, $DODFX, $VEU / $VXUS, among others.
You can also check out the piece I wrote on $VWICX, which is a value-tilted international fund. The tilting is minor, and itโs done a good job of beating the index without going to heavily into value names.
On a YTD basis, value, followed by quality, have been the top-performing factor groups.
So, what aboutโฆ 3-months? Yep, Iโve got that. But Iโm gonna spoil things: value won.
I can hear someone askingโฆ โAvery, doesnโt this mean growth is due for a rebound?โ.
The answer is no. Growth is never due for any rebounds, not until it outperforms the market in a statistically significant way. If you put $1 into small-cap value in 1927, and $1 in small cap growth at the same time, youโd have approximately $135,000 in your value fund.
Your small-cap growth fund, assuming it didnโt go to 0, would be at $2.50. Not $250. Two dollars and fifty cents.
I am a big proponent of value investing, if you didnโt notice already. Growth is great, at times: falling rates, lack of regulation etc. This is not that time.
However, we could see growth rebound following FOMC, and thereโs a LOT of puts out there for March 18th. I think the market is going to react sharply. Without clarity on Russia, I do not expect more than a 25 basis point increase. This could lead to a day or two of growth out-performance, but investors will need to remember that the Fed is watching and waiting.
As Iโve been getting more and more into visuals, I figured Iโd share one more with you. COAL PRODUCTION! China does lots of that. Lots of coal. They love it.
You can draw your own conclusions here, as I mostly am in this for the pretty graphics.
Iโm wishing you and your loved ones a safe and happy evening. Take care!
โAvery
Let's Get Visual
yes this is awesome
Great work, I appreciate the read