Don’t Focus On What’s Out Of Your Control
Investors are faced with navigating their capital through an environment where the signal-to-noise ratio has rarely been more challenging. Case in point, the two charts below highlight that both economic and trade policy uncertainty are approaching or exceeding their highest levels (outside of COVID) in the past fifteen years.
Uncertainty is kryptonite to risk assets, as it allows the imagination to run wild and push worst-case and best-case scenarios to extremes, depending on which way the wind is blowing. I don’t have a lot of insight to share in this week’s missive, as I find myself in the same camp as the masses – scenario planning for a range of outcomes that could play out in the aftermath of the tariff announcements set to be announced on Wednesday. While I’ve read, listened to, and spoken with many other savvy investors about their short-term, intermediate-term, and long-term views on how things evolve, the highest conviction take away from all of it was the lack of conviction.
Keep in mind that we’re analyzing the implications of significantly altering trade, economic, and geopolitical policies that have become deeply embedded in the World Order since the end of World War II. Making such a comment isn’t my attempt to be bombastic or overly dramatic but rather to acknowledge that I think it's impossible to know how this will play out.
Sure, with the S&P 500 down 5% for the year (-9% from its all-time high), the Nasdaq Composite down 11% for the year (-15.2% from its all-time high), the Russell 2000 down 10% for the year (down 18.2% from its all-time high), and the Dow down 2% on the year (down 7.4% from its all-time high) the bear camp has some vindication (numbers are as of Monday morning). The fact that gold is up +18% ytd, and bond yields have declined is more affirmation that capital preservation/defense has been the correct investment strategy for 2025.
Look, this week’s note is going to be intentionally brief and pointed, as I think it's more important for investors to focus on their own psychology than policy. The yet-to-be-announced trade policy will be what it is (and that’s not to make lite of its implications – its instead to point out that it is out of our control), and while we are looking down the pipe of monumental disruption, how you react and navigate your capital through the aftermath will be infinitely more important than understanding every digit of detail in the data.
So, rather than focusing on the unknown and what’s out of our control, let’s focus on what we know and what we can control:
Risk assets have repriced in anticipation of a growth scare that some investors, including ourselves, have been expecting to shake out in Q1/Q2 this year. The most recent update from the Atlanta Fed GDP nowcast is penciling in a contraction in economic activity of -2.8% for Q1 (-0.5% when excluding imports and exports of gold).
I surmise that the roughly 10–20% correction we’ve observed in most of the equity market has been marked to market in response to this reduced growth expectation. Correspondingly, credit spreads have widened over the last several weeks, and earnings estimates are being revised down more aggressively. It’s worth noting that the S&P 500 EPS of $270 for 2025 is still up more than 10% from the 2024 earnings of roughly $245 per share. Not to mention that the S&P 500 trading at 5,550 is still priced at a lofty 20.5 forward P/E, down from a peak multiple of almost 24x. This is all part of the process of recalibrating asset prices for reality.
If a growth scare is all that materializes, and at this point, that remains the base case, then I am of the view that stocks are within 5% of their ultimate lows for 2025. That being said, investors should start shifting their investment strategy towards going on offense rather than playing defense. Additionally, the optimistic scenario for Liberation Day tariffs is that they mark the peak in global tariffs, instead of other countries countering with tit for tat reciprocal tariff increases they counter with a reduction in tariffs so long as the Trump administration does the same.
Alternatively, suppose Liberation Day proves to be just the start of history in the making, with potentially dramatic market and economic consequences. In that case, risk assets are in the early innings of a major rerating that is set to unfold over quarters and years, not days and weeks. Let’s assume the growth scare persists into something more dramatic, with GDP contracting or flatlining over the next several quarters. That would certainly raise recession risk probabilities to a level where markets have to price them in. In such a scenario, earnings estimates would be cut 15-20%, and the P/E multiple would likely contract to at least its historical average of around 16x. Do the math: If S&P 500 earnings slide to $220 for 2025 and trade at a 16x P/E, we’re talking about 3,500 on the S&P 500 – roughly 35% below current levels.
I know, I know, that sounds so gloomy and reeks of fear-mongering. I agree, but I’m just putting the math on paper for you to consider because none of those estimates detailed in the above paragraph are outside the bounds of what history would suggest. If anything, they are generous, but we’ll leave it there as the point has been made.
Another theme to keep in mind is the potential unwind of U.S. exceptionalism. For decades, and particularly since the COVID-19 pandemic in 2020, U.S. financial assets have become the world's de facto piggy bank. The United States still accounts for ~65% of the value of all global stocks (73% of the developed market space), so there is still ample room for the mean-reversion to play out. We are witnessing something very rare, and it could be classified as a classic reversion to the mean. After all, the All-Cap World ex-US (ACWX) has only outperformed the S&P 500 in just two of the past twelve years; yet, it is up +6% ytd compared to the S&P 500's -5%.
Furthermore, it appears that the rest of the world, particularly Europe, is fighting back against the U.S. trade protectionist wave by selling the U.S. and investing in its home-equity market, which offers superior valuation metrics and is now improving its relative economic growth prospects. European investors held approximately $9 trillion in U.S. stocks at the end of last year – that is around 17% of the overall value of the U.S. market and not far off the market capitalization of all of Europe. This cross-Atlantic shift in Europe is causing European equities to be on pace to deliver their best performance this year since 1960. Tack on the fact that the Trump administration's desired weakening in the U.S. dollar is quickly unfolding – indeed, only six times since 1969 has the U.S. dollar weakened as much as it has over a four-month start to any year – and foreign markets have the kicker of a currency tailwind to go along with relatively better fundamentals and nationalistic capital flows.
As for the Fed, I remain of the view that the world has shifted from an era of monetary dominance to one of fiscal dominance which relegates the Fed to play a supporting role (no longer the lead) in all that transpires. Over the past week we have seen market pricing shift back to three rate cuts for 2025, and I expect that number to increase if equities continue to slide and economic growth weakens further. The biggest dilemma the Fed faces is a backdrop of stagflation (growth is weak while inflation stays elevated), which will handcuff them in the short term (they will be late in providing necessary accommodation), but my suspicion is that when push comes to shove, they will be more flexible with their inflation mandate rather than standing pat during a disorderly unwind in financial assets. After all, they have been a major contributor to the hyper-financialization that has swallowed up the U.S. economy.
Let me try to wrap up with some closing thoughts. According to our analysis, the growth scare that some anticipated is now evident in the data and is almost fully priced into risk assets at current levels. If this is only a growth scare, then I don’t think equities have more than 5% more downside from current levels, if that. However, for the S&P 500 to sustain a 20x multiple, the onus is on the hard data to convincingly hold up – as much of the survey data, particularly the forward-looking components, remains terrible. That is why I think, for short-term tactical reasons, this Friday’s jobs report is as important as the tariff details on Wednesday. A bad jobs report will set the tone for a growth scare morphing into recession risks.
What is perhaps most troubling from a U.S. economic growth standpoint is where the economy can find an offset to the overwhelmingly positive fiscal impulse that underwrote U.S. growth since COVID. I’m not saying it was all due to government spending, but the data doesn’t lie, and a lot of activity bootstrapped off the fiscal spigot running wide open. This administration is talking tough on ‘detoxing’ the economy from government largess, and while necessary, I hope they know that ‘cold turkey’ brings with it severe withdrawal.
So, what’s an investor to do? Return to basics. Focus on what you can control, and do your best to understand and appreciate what you can not control. Investing is both a journey and a destination. The last couple of years have been easy, and no matter how much we’d like it, they can’t all be like that. Sure, an easy recommendation at this juncture is to recommend taking less risk given the unknown and advocate full capital preservation mode, but for those that have been prudent and disciplined, I would be remiss in not saying there is more opportunity in risk assets today than when we started the year. No, that doesn’t mean we’re at a back-up-the-truck moment, but it's time to start identifying some opportunities and picking your spots to build out positions. For me, it's just that – having a plan to build out intermediate to long-term positions. This means buying 1/5th to 1/3rd of a position with the discipline to add to it over time or, if circumstances change, change with it and course correct. Be bold, but also be humble. Understand that your process, discipline, and temperament are infinitely more important to your long-term success than your ‘stock picks’.
Dan Niles has referenced a Charles Darwin quote as a guide for this year, which I think is very on point:
“It is not the strongest nor the most intelligent of species that survives, but the one that is most adaptable to change.”
The best poker players don’t play every hand – that is a mentality investors should foster for the foreseeable with so much potential change upon us. You don’t have to buy every dip, nor sell every rally. Some days/weeks are better served to sit back and watch, and other times are opportunities to act – that is well within your control as an investor.
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