Uncertainty has become abundant, and while that likely is the intent of this administration, it's reaching a point where it's becoming a headwind for markets and economic growth.  By now, I’m sure we’ve all read or heard some form of the Steve Bannon ‘flood the zone’ strategy pioneered in Trumps first term:

“ The opposition party is the media and the media can only, because they’re dumb and because they’re lazy, they can only focus on one thing at a time. All we have to do is flood the zone with shit. Every day we hit them with three things. They’ll bite on one and we’ll get all of our stuff done. Bang, bang, bang. These guys will never be able to recover, but we’ve got to start with muzzle velocity.”

Uncertainty is difficult enough for markets to try and price while confusion takes it to a whole other level.  Will tariffs be imposed or not?  How aggressively will immigration policy pivot and to what degree will it entail mass deportation?  Will the DOGE spending cuts have a meaningful impact or is it more political theater?  Will tax cuts be implemented or not, etc? 

This is where uncertainty devolving into confusion for capital markets becomes infinitely more difficult.  Even if there is a consensus on the probability distribution of the different potential shocks, there remains ample confusion on the economic impact of the shocks.  Let’s assume we all knew that a 20% across-the-board tariff was going to be imposed by this administration; valid arguments will be made for it being inflationary, others will argue that it puts economic growth on a recessionary path, and some will justifiably suggest it creates a backdrop for stagflation.  Moreover, some will see the Fed reacting with rate cuts given the negative growth impacts, while others will argue that the Fed will have to hike rates to suppress the potential inflationary effects.

The confusion compounds the reaction function of the different decision-makers in the economy.  This goes for both private sector actors as well as those designing public policy.  The official argument to impose tariffs on certain countries relies on targeting those countries where the U.S. runs a trade deficit.  As if tariffs were the sole solution to balance trade on a country-by-country basis.  This puts the Fed in a highly reactive state where they are at risk of waiting too long to take necessary policy action because they are waiting to assess the impact of these policy shocks on employment and inflation.  This confusion extends to the Treasury, which considers continuing to finance the deficit with short-term liabilities because the Fed remains in QT mode and allows Treasuries to roll off its balance sheet.  

Let me be clear in that whether one agrees with or disagrees with this administration's approach and/or strategy is irrelevant to markets.  Markets are in a constant state of analyzing changing probabilities on various future paths.  But the lack of momentum either up or down (notwithstanding a rising state of volatility) illustrates the difficulty markets are having trying to digest ‘what is what’, most markets are little changed over the last several months:

• The S&P 500 (SPY) is roughly 1% higher than where it closed following last November’s election.

• The Russell 2000 (IWM) is at the same price as in mid-October.

• Global Equities (ACWX) ex-U.S. are at the same price they reached in mid-October.

• Emerging Markets (EEM) are trading where they were in early-November.

• Crude Oil (USO) is at the same price as in early-September.

• Bitcoin (FBTC) is at the same price as in late-November.

The only asset that has made a material move to the upside is Gold (GLD), which makes sense in that it has long been viewed as an asset that moves inversely to uncertainty.  Following the +26% increase in 2024, gold continues to methodically march higher with a +12% advance so far this year.  To be fair, the move in gold has much more going for it than this administration's attempt to “make uncertainty great again”, but such a strategy is an additional tailwind.

So, what’s an investor to do with such a backdrop?  Many investors overlook the importance of existing conditions on the success or failure of yet-to-be-determined outcomes on policy actions.  I don’t have a high enough level of conviction on how things may play out to make a significant commitment in one direction or the other with client capital.  What I do know is that the setup, through the lens I view it, is already fragile.

• Investor positioning across retail investors, fund managers, hedge funds, and algorithmic trading programs are heavily loaded on the bullish side of the boat.  Household exposure to U.S. equities is at an all-time high.

• For the first time in six quarters, probabilities for a growth scare on the economic data front are rising.

• The labor market, while fully employed, is softening at the margin.

• Inflation bottomed last September and, while not likely to take off to the upside, is proving itself to be stickier than both policymakers and consumers would prefer.

• Global liquidity remains ample but is set to inflict negatively later this year (this is heavily dependent on what the U.S. dollar does).

• Equity valuations are near all-time highs (not a new development) and while earnings growth is expected to broaden out beyond the Mag7 in 2025, the aggregate level of EPS growth is set to moderate (rate of change slowing).

These existing conditions highlight the fragility already embedded in risk asset prices.  I’m not a big fan of the phrase “price to perfection,” but risk assets are priced for a whole lot to go right and very little to go wrong.  That’s not a great risk/reward setup when combined with an incoming administration determined to disrupt the status quo.  As a result, I think it is rational for investors to moderate their risk exposure at the margin.  No, I’m not advocating investors should sell everything, go to cash, and find a bunker.  But an elevated level of discipline, restraint, and patience makes a ton of sense.  After all, that is what the most successful investor of all time is doing.  Berkshire reported results over the weekend, and what stood out was that it was carrying a record cash pile of $334 billion, almost double the $167.6 billion it had held at the end of 2023.  Furthermore, the value of Berkshire’s equity portfolio stood at $272 billion at year-end, which is down nearly 25% from the $354 billion value it was at the end of 2023.  The Oracle isn’t even finding his own stock that attractive as Berkshire continues with its buyback halt.   

Look, there is only one Warren Buffett, and his objectives, constraints, time horizon, and risk profile are drastically different than ours. Still, no one can argue with his track record of identifying when opportunities exist and when they don’t exist.  Look at the oscillation in the above chart plotting cash as a percentage of Berkshire assets – the ratio is high in ‘05, ’06, and ’07 and low in late 2009 / early 2010 (he put money to work during the GFC).  Rising again, leading up to the COVID panic in early 2020, which then decreased as he found opportunities to put cash to work.  For him, market timing is more about being generally right rather than precisely wrong.  Few investors have the patience he exhibits over time, especially in an era like today, where everyone is attempting to keep up or outperform the holy grail of the S&P 500, which has become a concentrated momentum basket of equity securities.  It doesn’t take a rocket scientist to infer what he thinks about a stock market that has rarely been valued at current levels (see the below chart from Bloomberg’s Simon White).  

I can hear it already; no one cares about valuation anymore, Corey.  Haven’t you noticed that it’s all about TAM (total addressable market), momentum, AI, quantum computing, Reddit chat boards, and meme stocks?  Yes, yes, there is a hint of sarcasm there, but this is what you get from a market that is being driven more and more by mindless passive index flows where fewer and fewer investors are doing any due diligence at all.  Who cares about profit margins, discount rates, modeling cash flows, talking to management, or measuring and mapping economic data?  Alright, rant over, but one final comment.  While we may think of the Oracle as a dinosaur by age, the investment wisdom he has handed down throughout the years has and will continue to withstand the test of time.  

I want to circle back to where we started this missive with uncertainty devolving into confusion while holding asset markets hostage.  Accurately predicting the impacts of tariffs, deregulation, immigration, or any other policy coming out of this administration borders on impossible on its own, but even more so if you lack a clear understanding of where we currently reside in key macrocycles: growth, corporate profits, inflation, and liquidity.  Layer on top of this how the consensus is positioned, as a significant acceleration or deceleration in any of these cycles will move markets.

Measuring and mapping the combination of these dynamics is what provides us with signals to determine when is the appropriate time to adjust portfolio positioning – most importantly when asset markets transition from a risk-on regime to a risk-off regime.  Nothing is a certainty when it comes to investing in dynamic and complex systems like the global economy, but our work indicates a character change is underway in asset prices.  There is no way of knowing whether we’re looking at a mild 5% pullback in risk assets, an outright correction of +10%, or something even more dire, but we know that all the significant drawdowns start small and go from there. The same goes for risk-on regimes or bull markets.  It’s worth noting that equity market internals are already showing a significant level of deterioration under the surface: the S&P 500 is a little over 2% off its all-time highs, but 60% of stocks in the index are down 10% or more from their 52-week highs, while 33% are down 20% or more. 

One of the most critical concepts of compounding wealth is mitigating substantial drawdowns. That doesn’t mean you try to avoid or sidestep all drawdowns; volatility (both upside and downside) is the price of admission for the higher expected returns offered by the equity market. 

This is all a longwinded way of me saying we see enough signals in our research work to suggest now is not the time to be full risk-on.  Nor full risk-off.  We see a growth scare coming through in the economic data over the next couple of months, but as of now, that’s all it is – a growth scare.  Nothing suggests a deeper slide or economic recession is on the horizon.  For sure, that could change with the evolution of time. Still, we remain steadfast in our view that a diversified portfolio of high-quality equities, a combination of fixed income across the credit and duration spectrum, gold, and a plentiful pile of cash (that pays a nice yield) is a good asset mix for the environment we are in.  Our expectation coming into the year was that returns would be harder to come by and likely occur in fits and starts.  After two years of equities marching higher with modest checkbacks, investors should be mentally prepared for a more frustrating glide path to their portfolio balance.  That means dividends and interest income will play a more significant part, but it may feel like little progress isn’t being made because those cash flows are paid out over a full calendar year. 

As for the week ahead, we have a host of Fed speakers making speaking engagements throughout the week, but Nvidia’s earnings on Wednesday night will be the big market-moving event.  The focus will be on what they say about future demand, improvement in supply chain issues that have hampered Blackwell chip production, and if industry-leading profit margins have come under threat.  Beyond that, we have a PCE inflation report on Friday that will have some bearing on the interest rate market, but otherwise, it doesn’t spin the dial much in terms of Fed policy (unless it’s a meaningful miss in either direction).         

The articles and opinions in "Capital Market Musings and Commentary" are for general information only, and not intended to provide specific investment advice. Performance, dividends and other figures have been obtained from sources believed reliable but have not been audited and cannot be guaranteed. Past performance does not ensure future results. Investing inherently contains risk including loss of principle. Advisory services offered through Casilio Leitch Investments, an SEC registered investment advisor.

Copyright © 2023 Casilio Leitch Investments. All Rights Reserved.