Last updated on 2023-04-11
As the war in Ukraine grinds on, and inflation ravages the United States as it emerges from the COVID-19 pandemic, markets have become volatile. Growth names and tech stocks were hit hardest over the last few months, and Chinese stocks remain down. Energy emerged as a winning sector as a result of the tension with Iran, Russia, and OPEC’s refusal to pump more oil in the midst of the current crisis and the West’s increased sanctions on Russia.
However, the main movers in the market remain Fed policy, and it’s increasingly hawkish rhetoric. Inflation has jumped significantly. Anecdotal evidence points to massive inflation that is not captured in the official numbers (All Item CPI increased to 7.9% according to BLS data). I have seen gas prices above $5 in LA county for more than a week now. Groceries are costing $45 to $50 per bag for me, as opposed to the $25 in the beginning of the pandemic. And, perhaps most significantly, rents and mortgage rates are increasing (this is significant because housing costs make up the greatest percentage of Americans’ spending ~33% of monthly budget).
In this environment, I believe it is useful to look at 1974, when inflation began to spiral out of control and how the stock market reacted to an environment similar to the current one, but also distinct in several ways. From 1973 to 1974, inflation jumped from 6.8% to 11%. The Viet Nam war was ending, and the fall of Saigon was still a year in the future. Nixon was being impeached. The United States had recently abandoned the Gold Standard in 1971, and OPEC began the embargo of countries that had supported Israel in the Yom Kippur War.
Given the unique situation in 1973, it would be difficult to compare it to the present moment. But, it may be sufficient to observe the similarities in themes: there is tumult in geopolitics, energy markets, faltering belief in democracy and U.S. power/hegemony. Perhaps most similar, there is unrestrained inflation happening now, for the first time since the period of 1973 to 1982. While I do not believe we are headed back to 15% mortgages, I do believe that inflationary pressure is not transient, and it will last for at least the next 12 months.
Assuming that the Fed is behind the markets is now orthodoxy. See here, here, and here. . . So, we will likely be in a rising interest rate environment for the foreseeable future, and it may take the Fed some time to impact market rates.
This is an obvious consequence (to me at least) of the massive increase in money supply by 20x. More money in the system has to lead to inflation eventually, and it probably would have happened sooner, had it not been for the pandemic, the slowdown in the global economies as a result, and the Russian invasion of Ukraine.
Essentially, I believe that we are in a similar position to 1973, and given that, it is worth looking at what happened in the equities markets during that difficult period. On January 2, 1973, the S&P reached an all time high of 119.87. It would not beat that level until eight years later in 1980. Here is a chart of the S&P from January 1973 through 1980.
That low in September 1974? That low is 62.34, which is nearly a 50% loss from the high. Yikes!
From the recent ATH of 4,766, the S&P is only down 300 points to 4,463. However, growth stocks (I will use the NASDAQ as proxy) are substantially off from 16,000+ to 12,800. As a quick note, Chinese stocks (using FXI as proxy), have also reached new lows last week, and then bounced heavily on the news that the Chinese government would “stabilize” its markets and the belief that the Chinese government may hedge on its support for Russia.
Conclusion
I think it is clear that there remain substantial down-side risks in this current market. I am bullish on the long-term prospects of both the United States and Asia. I like the potential for upside in the Chinese stocks presently, and I remain committed to the growth story of SaaS stocks in the US markets.
I remain broadly diversified in US equities in 50% of available funds, and I committed to SaaS and hyper growth companies using 25% of funds. I will use the price fluctuations to commit my remaining cash allocated to this thesis and to rebalance that portfolio. For the remaining funds (which are in a tax advantaged account), I will begin to buy into China related funds and try to be opportunistic as markets swing to oversold conditions.
I think some caution is warranted, as many markets remain “falling knives”. I must remember that there is no need to catch the exact bottom, and that I have always been better served by waiting for the bottom to form and the reversal to begin before committing the bulk of funds to the market. I already made the mistake of committing some money to the Chinese thesis too soon. In the long run, this will likely be a win, but it was an unnecessary risk, especially considering the volatility that will likely come, and that which was observed this last week.
Finally, if the war in Ukraine becomes a stalemate, and Russia just pounds the infrastructure and people with bombs, what are the consequences? What is the economic fallout from Ukraine’s potential inability to plant grain on commodity markets? On geopolitics? What are the consequences for China depending on their ability to sit on the fence? What if they lean one way or another? What are the consequences for Europe and the US?
Strange times. . .