Back in April 2021, the theme of Outlook & Trends was the ”Times They Are A Changin”. And indeed, they have changed and are continuing to. The last three months have featured a war, a global runaway artificial intelligence race, and a change at the helm of the Federal Reserve that may undo the friendly policies that have ruled the markets since the Greenspan era ended in 2006.

The Economy

The greatest economic change has been a turnaround in the inflation trend. It had been drifting slowly down as the Fed kept interest rates steady near 3.6%. The Iran war changed that, by temporarily driving up the cost of gasoline by 60% at its peak. The annual change in the CPI is now 4.2%. The parallels to the 1970s’ economy continue, as there are now signs that the Fed, under the new Chair Kevin Warsh, will be considering raising interest rates again. The economy continues to grow, registering a 2.1% rate in the first quarter, largely due to the increased competitive scramble to build an artificial intelligence infrastructure. Inflation resurgence has not helped consumer confidence, which continues to challenge the lowest levels in fifty years. Existing home prices continue to increase slowly, buoyed by a 4.4 % increase in Northeast prices over the last year, although mortgages have also increased with the rise in inflation, taking a bite out of affordability.

The Markets

All things AI, especially semiconductors stocks, have been the shooting stars in the last quarter. The Magnificent 7 appears have been put out to pasture, supplanted by investors’ latest heartthrob. Not long ago, the case being touted for the Mag 7 stocks was that they deserved their stock prices because they generated a lot of free cash and did not need much in the way of capital assets. Like many Wall Street stories that rationalize whatever the latest fad might be, all that has turned on a dime as the companies are now spending their free cash on capital assets, acquiring infrastructure like data centers and power generation capacity to support AI.

Value stocks have been picking up the slack left by the former market leaders since the middle of May. Health care, financials and real estate have picked up the baton, at least temporarily. Intermediate term treasury bonds have returned about zero so far this year, continuing to be bested by short term bonds and floating rate notes. The other prior star attractions, gold and bitcoin, are suffering significant downdrafts measuring 30% and 50% from their peaks respectively and are still falling. While we watch semiconductors fly, these two are good reminders of what will happen when values get separated from reality.

Prediction vs. Preparation

The April issue of Outlook & Trends discussed the economic conditions of the 1970s and their similarities today within the context of repeating natural cycles. To some extent, many cyclical phenomena continue to occur because they are based upon the length of human memories and the forgetting of lessons learned from previous generations. We might like to think that the current generation is enlightened and can change the course of human events, but as the alien culture, The Borg, declared in the TV series Star Trek, “Resistance is Futile!” Likewise, as far as the markets go, it is tempting to declare, “Prediction is Futile!” as we attempt to coax knowledge of the natural trend out of data that is full of noise.

However, if we concentrate more on the so-called forest rather than the trees, the longer price trends rather than today’s news and hype, or the repeating cycles rather than the noise, navigating the markets can be more manageable. We know that bear markets follow bull markets, just as surely as winter follows summer. The question is not whether. It is when. Predicting may or may not be helpful. Preparing is.

Historical cycles say that at some point in our future there is likely to be another bear market that cuts the major indexes in half (temporarily) and reduces the value of the segments that were the previous leaders by 80%. They also says that prices will recover, but it may take a decade or more. For young investors who do not mind a temporary loss and can look forward to getting a generational bargain with great anticipation, they can capture an exceptional opportunity to build wealth. For older investors who need to use their previously built wealth through the “temporary” period, this can be a very difficult challenge. The first step in preparation is determining which of these types of people you are, or like many, where you fall in the middle. The next step is to prepare to deal with it appropriately.

The first group can prepare by saving consistently from a lifetime of paychecks and ‘dollar cost averaging”. The second group can prepare by reducing risk through asset allocation and market awareness. Before summer turns to winter, there are warning signs of trees beginning to shed their leaves. Although several leaves turning color does not mean that there will be no more hot days. For the prepared, the leaves could be a reminder to call the furnace company to arrange a maintenance check.

 

When a bull market changes to a bear market, there are signs that a change is occurring. Markets are not as predictable as the weather, so the signs are inconsistent and not always reliable, but typically the former leaders, like the Magnificent 7, lose their appeal at these times. Exciting “growth” stocks (SPACEX, AI, etc.) often display a last fling rapid rise, then burn out giving way to their mundane “value” cousins (health care, utilities, and real estate). The chart shows the recent runup in semiconductor stocks (Upper blue line) and AI stocks (brown line), while the Mag 7 former leaders (green line) are now lagging the S&P 500 (lower blue line).

 

Chip stocks have had a phenomenal 75% rise over the last three months, while value stocks have surpassed the Mag 7 former leaders. Is the ultimate shift of market character happening today? Or is this just a random leaf turning color well before a still distant winter? Doing your homework, understanding the markets, seeing the trends, avoiding emotional decisions, and managing risk will help you in the event of any scenario. Although there are signs popping up that have accompanied previous market tops, they have not always been meaningful. Prediction may or may not be futile. Preparation is not.