Category: Market Commentary

By John Goltermann, CFA, CGMA

“When I was young, I thought that money was the most important thing in life. Now that I am old, I know that it is.”

– Oscar Wilde

The 3rd quarter 2025 was another relatively buoyant one for stocks. A lot of the daily moves in stock prices during the quarter were related to the outlook for future Fed policy as a consensus developed that the Fed will cut rates a couple of times through the end of the year with further cuts next year.

The labor market has softened a bit with an uptick in unemployment and a decrease in the number of job openings, which gives the Fed some room to cut rates. With the prospect of rate cuts, traders continued to bid up the prices of various speculations such as crypto, and Magnificent Seven stocks (Apple, Google, Tesla, Amazon, Meta, Microsoft and Nvidia). But interestingly, when you look at year-to-date returns, you see that gold mining stocks, and emerging market stocks have far outperformed both. You wouldn’t know that listening to the financial media. As of this writing, gold miners are up 86% and emerging market stocks are up 20% for 2025 vs. 10% for Bitcoin and 10% for the Magnificent 7.

Why?

Bitcoin and the Magnificent 7 have underperformed many other investments probably due to exhaustion of their multi-year rallies. Some of it is likely related to stretched valuations. And some of it is probably due to waning market liquidity and high debt levels among traders. But a lot of it is because of a slowing US economy, a weak dollar and the risk of stagflation.

If we look at the ratio of leading economic indicators to current economic indicators (chart below), we see that it has declined. This reflects an increasing probability that the US economy will slow, which is a primary reason that the Fed has been signaling rate cuts ahead. For fifty years this relationship has reliably preceded recessions.

Investor behavior around this has also followed similar patterns: High stock prices reflect traders’ complacency from lagging measures of economic growth that still appear strong. That hope/optimism can support equities for a time, but the eventual and inevitable convergence of data and reality might begin to deliver volatility in some stock prices. As stock prices today remain near all-time highs, it’s safe to say that most investors have dismissed the signals sent by this relationship above, and that the consensus outlook has, so far, mirrored misplaced confidence seen in past cycles.

We don’t want to have misplaced confidence when many others do. That can be hugely costly. Especially at a time when markets are priced for perfection, and trade at record valuation levels. There is very little room for error today. Believe me, we would love to jump on the bandwagon and make massive returns by doing what everyone else is doing. But markets don’t work that way because no “one thing” works forever.

Instead, because of this data and other factors, we believe that it is prudent today to be more conservative in our asset allocations, diversified into other asset classes such as global and uncorrelated stocks (that have strong upside cases), to own resource producers as beneficiaries of AI and as a hedge for stagflation, and to take more defensive, value-oriented positions. ‘Conservative’ does not mean to make less money in an environment of positive returns. It can mean to make more money safely through non-consensus investments, and to lose less when the most popular investments do not live up to their high expectations.

Today’s is an investment environment where most advice given by professionals is to just stick with the S&P 500 or own a portfolio similar to the S&P 500. That advice is very similar to prevailing views in the late 1990s after the S&P 500 delivered just over 20% average annual return in the prior 10 years. But then the 2000s came. The table below shows the returns for various asset classes and styles in the 10 years after Dec. 31, 1999:

ASSET CLASS	10-YEAR CUMULATIVE RETURN FOR PERIOD ENDING 12/31/2009
S&P 500 Index	-5.9%
US Large Cap Value	55.8%
US Small Cap Value	139.5%
International Large Cap Value	90.7%
International Small Cap Value	190.9%
Emerging Market Stocks	147.8%
Equity REITs (Real Estate)	148.4%
Short-Term Bonds	54.0%
Gold	274.8%

Sources: MSCI, Bloomberg US 1-3 Year Government/Credit Bond Index, FTSE NAREIT, S&P Global Inc., London Bullion Market Association

The point is that return patterns differ across various asset classes and that past returns do not predict future returns. If past returns did predict future returns, investing would be easy. What matters is valuations, consensus views and widespread biases reflected in today’s prices. US large cap growth stocks have had an extraordinarily run (15 years) of outperformance that has carried the S&P 500, and as a result, those stocks are now at a point where their prices are not well-supported by likely future growth rates. It is unlikely that US large cap growth will be where the money will be made over the next 10 years.

We are not anticipating a crash, nor predicting super tough times ahead. If we get a recession, that’s OK. Recessions are healthy and normal. We just want to share our rationale for being conservative while others throw caution to the wind. After all, the goal is to protect capital and make money no matter what the economy or the markets do.

By John Goltermann, CFA, CGMA

“The big money is not in the buying and the selling, but in the waiting.”

– Charlie Munger

If you blinked, you missed it. The 2nd quarter carried much drama with a major decline in stocks on the heels of Trump’s tariff announcements then a rebound back to where they started as full
implementation was “paused” for negotiations.

I won’t rehash the details, but, in short, investors de-risked with the economic uncertainty that comes with effective tariff rates in the US at the highest level since the 1930s. But as pauses were announced, speculators stepped back in and juiced stock prices on the hopes that tariffs were simply a negotiating tactic, that there would be no economic impact and that the selling was overdone.

Foreign stocks have performed well this year as US stocks and treasury bonds are flat-to-down. But gold ended up the big winner as it has now arguably replaced US treasury bonds as a safe haven investment. This, in my opinion, is not a situation that investors want, but were forced into wholly due to fiscal mismanagement in Washington. That mismanagement has occurred over a long period of time and is a result of political incentives enabled by the US dollar being the world’s reserve currency: A paradigm that may be in the early stages of unwinding.

When we had a near 20% selloff in the S&P 500 in late March/early April, interest rates went up and the dollar went down almost 10% (see chart below). Normally in a “risk-off” environment, meaning when market participants are selling stocks, bonds rally because of a flight to (perceived) safety, and the dollar rallies because participants buy dollars to pay back dollar-based loans (large amounts of the borrowing in markets are non-dollar-based loans). That did not happen in the last quarter.

Source: tradingview.com

What does this mean?

In my opinion, this largely reflects widespread recognition that the US fiscal situation is untenable. With $37 trillion (and rising) of treasury debt and rising interest expense, the US may be near a tipping point where kicking the economic can down the road through interest rate suppression and fiscal spending is not a viable strategy any more.

The recent enthusiasm on the part of stock investors for a more business-friendly administration economy is understandable. But caution in stocks is still warranted because valuations (on US stocks in aggregate) are much higher now than they were in 2017 when Trump 1.0 began (see below). The chart below shows Warren Buffett’s favorite market environment indicator (total US stock market value (market cap) relative to US economic output (GDP)). As you can see, total US stock values are around 220% of GDP and they were around 120% at the beginning of Trump’s first term. That means they are much more expensive now.

Source: www.marketsentiment.co

The chart below is one reason our portfolio is not set up to track the S&P 500 and why we are cautious overall: The so-called equity risk premium shows high-risk territory. The equity risk premium is the difference between the ‘earnings yield’ on the S&P 500 (sum of all S&P 500 EPS weighted by market cap) divided by the S&P 500 price) and the yield on the 10-year Treasury. Data sources differ, but right now I calculate the S&P 500 earnings yield to be 3.62% ($218.87/6034.40 as of this writing) and the yield on the 10-year is 4.41%. So, the spread is -0.79 and the mean is probably somewhere between +2.0 and +3.0.

Source: Financial Times

Think of the equity risk premium as how much one is compensated for holding equities vs. simply earning interest on a risk-free asset like the 10-year T-note. Right now, you earn less by owning stocks (and taking on equity risk (downside)) than you do by owning 10-year Treasurys. From a long-term positioning basis, S&P 500 owners are not well-compensated for their risk.

We’re notching all-time lows again on this spread at a -0.79, which is not a stable situation. Or looked at differently, S&P 500 owners are betting a lot that 1) long-term Treasury rates will come down big time, 2) EPS on the S&P 500 will exceed what is expected; or 3) that inflation will be good for the S&P and bonds won’t sell off if it increases. All of those, amidst everything happening (and vs. history), are likely to be bad bets. But, of course, are possible.

The equity risk premium can be distorted by factors such as excess market liquidity, leverage (heavy retail participation in short-dated options), complacency, mass indexation and algorithmic investing, heavy foreign investment through high capital account surpluses, and fiscal spending in the US (higher rates because of deteriorating creditworthiness of the issuer (the Treasury)). I believe all of the above are happening, so in the near term this spread has limited use in predicting the near-term direction of markets but can be used to understand the broad risk environment and to guide positioning.

A word on Israel-Iran: This piece is being written four days after Israel’s attack on Iran and its nuclear capabilities. This attack was not entirely unexpected and probably the inevitable result of decades of proxy wars and posturing. The middle east has been unstable for a long time. Iran’s nuclear goal is to make its regime more stable and permanent through nuclear threats. Israel ‘s (and the US’s) goal is to stop that from happening.

If Iran is successful, it would make Israel less secure and the US’s enemies more powerful. The US’s fear is that if Iran is successful, it could become a regionally dominant player. If this happens, it would likely be allied with the Russia/China combination, which, obviously, threatens the United States and the West. The big question is whether this conflict closes the Straits of Hormuz, which would certainly impact the global economy. If oil prices stay high, and other problems arise, the risk of stagflation goes up. So, this is high stakes geopolitics.

One of the factors that have helped returns this year is our positive exposure to rising geopolitical risk through defense companies, resource investments and gold, as well as positioning for the rising risk of stagflation through foreign stocks, insurance companies and short bond durations. We have been cautious for various reasons mentioned, while other investors throw caution to the wind and chase the S&P 500 and the AI craze. In terms of AI, we do think it will continue to advance. But how to invest in AI is a different matter. It is highly possible the easy money has been made on the technology side and that valuations now reflect bubble-level enthusiasm (see chart below). But what many people forget is that AI will take tremendous resources to power it via electricity (energy), mining, land and people and going forward, given where valuations are, this is likely where AI-related money will be made.

Source: Tavi Costa, Bloomberg

By John Goltermann, CFA, CGMA

“There is only one way to happiness and that is to cease worrying about things which are beyond the power of our will.”

— Epictetus

Markets are speaking.

Significant re-positioning has taken place in investment, commodity and currency markets since the inauguration in reaction to the return of Donald Trump and his subsequent policy pronouncements. In this piece, I will try to summarize what I see and potential outcomes of these policies and how they might impact investors.

Nothing lasts forever. So far this year for equity markets, what had worked well in the last two years (megacap tech), stopped working. Apart from their high valuations, there are many reasons for this. Tariff threats, inflation risks, persistently high interest rates, and slowing growth to name a few. As a result, capital has shifted out of positions that could be viewed as risky or expensive. The Magnificent 7, Apple, Amazon, Meta, Google, Nvidia, Tesla and Microsoft, are collectively down 13% year-to-date as of this writing.

But foreign stocks have worked well. So has gold, long maturity bonds, and major foreign currencies versus the US dollar. Small company stocks, which are tied to the strength of the US economy, have declined significantly, as has crypto, tech, and economically sensitive investments across the board.

Why?

In a word, de-risking. Myriad economic statistics support the case for a broad slowing in the US, but I won’t list them here. Economic slowing began in the late summer, it is continuing now and will likely continue.

To cut to the chase, in the wake of the threat of a trade war, global investors are re-allocating away from the United States and repatriating their capital back offshore. This process is just beginning and will likely continue if a full out trade war materializes. The dollar has weakened, defensive commodities such as gold have traded up, and foreign equities have outperformed. Why? Because tariffs boost inflation, inflation expectations, and impair growth. That is what has been being priced in.

For us, we believe the best approach is one embraced by Stoics, which is to ‘imagine all possibilities and therefore fear none’. Almost any policy proposal is possible, and we can’t rely on any one pronouncement, so we need to consider what is actually being done. The ability to ignore political theater may end up being our superpower as we focus on where values exist while our competitors busy themselves trying to parse signals out of the noise. Very often there are very few signals in the noise.

What we do know is that Trump is pushing for tariffs as a revenue source, and taking aggressive action with DOGE, all while trying to push interest rates lower (a further decline in the S&P 500 would help achieve that). This signals his seriousness about making room in the budget, likely for a tax cut to support growth. We expect a proposal for that later this year.

We also know that to reduce trade deficits necessarily means a reduction in the capital and financial accounts surplus because the math of the balance of payments is that the US current account (of which the trade account is a large component) has to equal the sum of the financial and capital accounts. If the current account deficit declines, then the sum of the capital and financial accounts (currently in surplus) will also decline dollar for dollar. This would mean an outflow of capital from the US because those surpluses are foreign investment in the United States, much of which is stocks and bonds (about half is invested in US Treasurys). And if that capital goes back home, it has investment implications

The reason we have a trade deficit is because we import more than we export. But it is also important to know that the US is a relatively closed economy as only 4% of our economy is net imports ($1.2 trn net imports vs. $27 trn US GDP), so trade is important, but not existential.

Therefore, because of the trade deficits, foreign capital, through the capital account surplus, has supported low interest rates, propped up economic growth and boosted asset prices in the United States, and in the process provided liquidity and enabled the explosion in debt, the expansion of government and fiscal spending. Some things good, and some things bad.

But a trade war risks a disorderly unwind of that paradigm, so the risk for US assets prices is heightened, especially the overpriced ones. And money flowing out of the US makes foreign securities more attractive than in the past. Especially because many are much cheaper. A trade war also increases risk for growth overall as economies must recalibrate to new trading relationships, more expensive capital, lower growth, etc.

That is where we are. We can’t handicap or predict how the future will unfold, but markets are adjusting to these risks and it could continue. We expect fiscal stimulus in Europe and China to boost their domestic economies and for them to ramp up investment in infrastructure and defense, but no comparable stimulus here apart from a possible tax cut down the road.

Many companies directly impacted by a prospective tariff war have already priced in that outcome so a reprieve would likely boost some of those stocks. I believe it’s a fairly safe bet to look for continuing dollar weakness over the longer run, which is an environment for which Townsend has been positioned for some time. And our value-oriented approach should help mitigate the high risk of permanent losses that exists in overhyped, overinflated tech darlings. AI is certainly an area where investment will continue, but its extraordinarily difficult to assess the impact of DeepSeek and other technological advances on that market, and calls into question the need to invest trillions in chipsets and data centers. There is a significant risk of overinvestment and poor returns in AI going forward. Overinvestment in tech and telecommunications certainly occurred in the hype of the late 1990s and those investors suffered greatly.

All of this was written in the middle of March, and much will have changed by the time you receive it. But our consistency of approach will not change. Nor will we react to what other people are doing or saying or make trades based on guesses of what other people will do. Good businesses are good businesses, and their stock prices should increase over time no matter what happens to the economy, to markets, or in the political realm. As long as those businesses make money, reinvest it wisely and compound their stockholder equity (and we own the shares at good prices), they should be worth more…later. And that is the goal – to own investments that have a strong case to be a lot worth more in the future. And that stoic focus makes a lot of the noise and media hype of today unimportant.

By John Goltermann, CFA, CGMA

This past May 4, I was lucky enough to be invited to attend the 150th running of the Kentucky Derby. The race was an exciting mix of fashion, cuisine, gaming and horses – one I would highly recommend for anyone to do at least once. The whole experience, and the way wagering is done in horse racing, got me thinking about investment markets and some of the conversations I have had with clients who have compared investing to gambling.

In my strong opinion, an investment is not a gamble, and a gamble is not an investment. While each involves a payoff or loss, they are not the same. Investments are owned claims on productive assets that have underlying value. Those claims are continuously re-priced by market participants in response to a variety of factors. By contrast, a gamble depends on a single, event-driven outcome – a win or a loss. One and done.There is nothing of value behind the money put down on a gamble – just the prospect of a favorable future outcome. Yes, you can opt to gamble again, but each outcome is generally independent of the previous outcome.

Serious long-term investors such as Charlie Munger would cringe at the idea of comparing investing to gambling because they take the process of valuing claims seriously. With investments there are a multitude of variables that factor into pricing and price changes. But if we had to compare investing to something, we can make a case that it is similar to a parimutuel activity. Like odds on horses, investments are priced by a consensus of others who put real money down. Those prices reflect expectations of future results. Results of what? The future operating results (free cash flow to shareholders) of the company. And since the price always reflects expectations for future performance, and because there is no finish line — it is a race in perpetuum.

Parimutuel betting involves many players who place money on a single event where the entrants are ranked in the order of their finish. It has a nearly 150-year history, going back to 1865 when a Paris perfume shop owner named Pierre Oller figured out a system of wagering on horse racing that circumvented the problems of notorious bookmakers and a lack of regulation. Pierre would sell interests in individual horses through an auction pool, with each horse’s price (the odds of a win) being the stated odds of winning. These odds are determined by the total money coming in on one race in proportion to the total bet on each horse. In parimutuel betting, the odds are not the actual probabilities of winning…just the crowd’s consensus perception, as reflected by real money down.

In a parimutuel system, bettors wager against one another. In fact, parier mutuel means “to wager among ourselves”. The goal in a parimutuel system is not necessarily to pick the winner of the race – it is to pick the horse whose actual odds of winning are far better than the stated odds (the price). For example, rational bettors would always put their money on a horse whose stated odds (also the payoff) are 8:1, but whose actual odds are 5:1. In a rational world, these bettors would place such bets an infinite number of times even though they would lose 4 out of 5 times. The same principle holds true for investing.

In investment markets the race is being run every second of every day. There is no end — just prices(the odds) changing continually. Changing stock prices reflect changing expectations of future performance as the race continues in perpetuum. News releases and financial reports provide updates on the contestants performances and condition. When prices move up, other investors have expressed the view that the odds of “winning” have improved; when the prices move down investors have expressed an opinion that the odds of “winning” have declined. These price changes are independent of the actual results. And, as with horses, price movements generally do not reflect whether the actual odds have changed or not – they just reflect the amount of money people are willing to put down.

In parimutuel betting you are paid at the end of the event. Within investment markets you can cash in your investment at any time at the stated price and accept the payout.Or you can hold the investment if you believe that future results will exceed the results that are “priced in”.Think of the stated odds on a horse as its “price”. If you place your money on a 5:1 and the odds move to a 3:1, you will earn a gain. If the odds move to 8:1, you will suffer a loss. In investment markets, the odds (as expressed by price) can change for or against you at any time simply based on other people’s (or computer’s) perceptions. If this is the case, it follows that investors must determine what they believe an investment’s real odds are – and balance this against what expectations the current share price reflects. Since there is no end to the race (only changing prices), the goal is to look for mispricings (actual odds better than stated odds).

Occasionally, prices move to levels where accepting or avoiding certain investments becomes an easy decision: the payoffs are either too great or too insufficient. In horse racing, a heavily favored horse may carry a 1:5 odds (meaning a $5.00 bet earns you $1.00 if you win) may not be worth the risk. Cisco Systems Is a memorable illustration of this (but not the only one). In late 1999, everyone knew Cisco was a fantastic company, had great products, and was dominating an exploding market (the internet). High expectations of magnificent future performance were reflected in the price. But, if you purchased Cisco’s shares in 2000 when everyone else had already bet on them, it would be a bad bet because the stated odds of winning (the share price) would be high and the potential payoff would be low (such as a 1:5 odds on a horse). Indeed, Cisco today is still 40% below its 2000 high, even though earnings per share are up 5-fold since then,why?The payoff (the stated odds) was too low relative to the risk. Avoiding bad bets can be as important as making good ones.

To add a layer of complexity, investors also need to be cognizant of factors that can distort the system-wide price/value relationships. For example, when a central bank floods markets with liquidity, it may inflate prices (stated odds of winning) across the board. Or when a large number of investors (index investors) decide not to select individual investments, but rather to simply allocate capital pro ratato those with the highest prices (lowest payoffs) –price distortions can persist. Eventually these anomalies get reset.

In my opinion, much of investing is about understanding the expectations that are implied by prices. This is why time is well-spent, as Charlie Munger advises, analyzing the actual odds relative to the stated odds. Often, people (and computers) invest in what they view as the likeliest winner, but without regard to price and payoff. And because of this, the prices/odds of the perceived “best” investments can rise to levels that make them super-risky (because so many have placed the same bet). Likewise, prices/odds on perceived “risky” investments can decline to levels that make them safe (because so many investors avoid them) and they carry high payoffs. This is where so many investors get tripped up: it’s not only about just trying to own good things, but also about prices. Ultimately, it is better to allocate capital to high-quality assets where payoffs are high, and risk of loss is low.

To summarize, we do not consider investments to be gambles, but there are certain parallels between the activities of investing and parimutuel betting that are worth considering. As Charlie Munger has said, “You’re looking for a mispriced gamble. That’s what investing is. And you have to know enough to know whether the gamble is mispriced. That’s value investing.” We “wager among ourselves” because one person’s loss can be someone else’s gain (opportunity or otherwise), but distortions do occur from external factors that impact sentiment and prices.

“Mimicking the herd invites regression to the mean.”

– Charles T. Munger

By John Goltermann, CFA, CGMA

In the 1st quarter of 2024 the same dynamics were at play as during the 4th quarter of 2023. Financial conditions were easy amidst rising home prices, stock prices stayed buoyant, and the official rate of inflation eased. Stocks trended upward due to the “muscle memory” of passive, quant and algorithmic investors that mechanically dump money into index funds and programs. It is “muscle memory” because this large cohort of investors all do mostly the same thing, react the same way to the same data and buy the same stocks. For now.

The economy also has remained resilient — defying many of the doomsayers’ predictions of a recession. The majority of gains in stock prices, however, were largely concentrated in a handful of mega-cap tech stocks. Narrow leadership like this, where just a very few positions carry the market higher, argues for continued conservatism in an investment approach.

Why?

Markets with very narrow leadership have often been seen to precede strong bear markets. This is not a prediction or a warning, but rather a case for us to continue paying attention to risk. The following chart shows the level of concentration of the top 5 companies (as a percent) of the S&P 500 through time. It illustrates that the current combined weighting of the top 5 stocks in the S&P 500 has approached that of the famed “Nifty-Fifty” era of the late 60s-early 70s. The Nifty Fifty refers to the large companies that dominated the indexes at that time that investors believed could be bought regardless of price. That belief was false and those stocks dramatically underperformed for a long time because they simply became significantly overpriced. Price does matter.

A Look to the Past

The narrow leadership of the post-2008 crisis, currently called “the Magnificent 7,” has been extraordinary. But the history of rallies led by a handful of companies suggests that special attention should be paid to changes in trend because the ensuing bear markets have been harsh. I am not trying to make a case that today’s level of concentration is unprecedented, or that things are about to fall apart. Markets have indeed been concentrated before, if not more concentrated. And conditions can remain stable for a while.

But it is important to remember that the “Nifty-Fifty” era I mentioned before was followed by the punishing stock markets of the 70s. The Internet Bubble at the turn of the century, also led by a handful of stocks of technology companies, resulted in an over 80% decline in the NASDAQ index (composed of mostly technology stocks) and a tough broad-based bear martket in the early 2000s. The rally that preceded the 1929 market crash was heavily concentrated in radio and a relative handful of other companies. In the 19th century, narrowly led bull markets concentrated in canal and railroad shares were also followed by sharp market downturns.

Things Have Changed

Many things, of course, are different now. The Federal Reserve intervenes regularly with a heavy hand to create liquidity. It even buys securities outright to prop up prices. Market structures too have changed: Huge amounts of capital are allocated to so-called ‘passive investments’, which track indexes – the S&P 500 being by far the most popular. Passive investments now represent 53% of total invested assets, up from 10% in the year 2000 . And when passive investments are wildly popular, by definition, the most money automatically goes into the largest stocks. Passive investors care little about price.

David Einhorn, the CEO of hedge fund Greenlight Capital says that because of the dominance of passive and ‘quant’ investors the market’s pricing mechanism is “fundamentally broken.”

A Deeper Look at Passive Investments

The popularity of passive investments is understandable. They offer low fees, an ability to gain diversified exposures and are tax efficient. They are easy to implement, super-liquid and intellectually undemanding. Also, 80% of actively managed mutual funds have historically underperformed broad market indices – further contributing to their appeal, (there is a reason that explains this but it is beyond the scope of this article).

But great results in anything are rarely achieved by being “passive.” Of course, that is true in any aspect of life whether it is relationships, careers, health or our investments. The ease of use of passive vehicles has reduced the desire by many people, including many investment professionals, to acquire investment knowledge obtained by study and experience. Passive investments, therefore, have created a large pool of investors with limited skills in coping with adversity or adapting to a changing opportunity sets.

The experience of most passive investors has been a march higher since 2000 as the Federal Reserve has squelched market volatility through suppressed interest rates, quantitative easing and money printing. And passive investments have grabbed an increasing share of stock investments. Thus, confirmation bias, recency bias and complacency have set in.

What is confirmation bias? It’s a human tendency to pay attention to data and opinions that only support existing views. What is recency bias? It is the tendency to put excessive emphasis on experiences that are most recent in your memory. These are psychological traps that lead people astray, but are difficult for many to overcome. As such, they are extremely important to understand and be aware of. Superior returns in indexes in the recent past have created both confirmation and recency biases that indexes must be superior. Increasing adoption of this belief has created herd behavior. And herd behavior has created risk. That is where we are.

The Impact

How will passive investors respond to large declines associated with bear markets when they inevitably arrive? Instead of looking at price declines as a source of long-term opportunity, investors with modest experience and negative returns may be more prone to emotion-driven decisions. And this could easily create greater downside risk for both the passive investor and capital markets in general – making investing with a ‘margin of safety’ hugely important.

Since investors do not deal in certainties they are better served by spending time understanding pricing and risk. Making predictions is futile. It is important to see today’s era as an array of prospective catalysts that could produce adversity and market volatility. Stock market valuations and investor optimism are at very high levels. The global economy is burdened by an unprecedented level of debt, geopolitical turmoil is rising, and the risk of recession has increased.

Recessions often begin – seemingly – out of the blue when economic activity falls enough to set in motion adverse feedback loops that cause unemployment to rise. Right now, households have run out of excess savings and default rates on credit cards and auto loans are skyrocketing. All at a time when the S&P 500 is super-concentrated and trades at a large premium to fair value. This is why we seek investments with a margin of safety and in great companies that are reasonably priced. The media-hyped speculations of the recent past, such as Nvidia, that are up 10-fold in a short period of time can easily trade down 90%.

The most sensible approach to this type of environment, in my strong opinion, lies not in passive investing, but in investors becoming more engaged and more active in the management of their financial resources. The effort to become a better informed, more active investor will reward, not only to those who choose to make their own decisions, but those who prefer to have their investments managed by others because it will improve their ability to ask well-informed questions. In our business, we enjoy engaged clients.

Here at Townsend, we spend a lot of time on our investments and believe we own investments with high upside and low downside. From year-to-year, we can’t know how other people will price them, but all possess the ingredients for higher prices — later. We try to apply the lessons of Buffett and Munger in the effort to earn you high returns without exposure to the large downside risks that so many other investors unwittingly own today.

If we can answer any specific questions about what is currently happening in the market and what that might mean for you, please don’t hesitate to reach out to us.

By John Goltermann, CFA, CGMA

Charlie Munger passed away on Nov. 28, 2023 at age 99 — 34 days short of his 100th birthday. Probably best known as Warren Buffett’s business partner in the world’s greatest compounding machine, Berkshire Hathaway, Charlie was one of the greatest minds of the 20th century. His observations and ideas have had a profound impact on me.

According to the Wall Street Journal, Munger possessed what philosophers call epistemic humility, which is a profound sense of how little anyone can know, and how important it is to be open to changing one’s mind. He was a fiercely independent intellectual who, in the words of Buffett, “Marches to the beat of his own music, and it’s music like virtually no one else is listening to.”

When asked the secret to his success, Munger answered, “I’m rational.” He was a voracious reader and drew from his study of psychology, economics, physics, biology, and history in developing a system of multiple mental models to cut through the difficult problems of complex systems. Adopting this approach to thinking is difficult but using its core tenets helps provide clarity and maintain objectivity – both being super-important for investors.

There are too many great Munger quotes to include in this article but they are all available online with a simple search. Poor Charlie’s Almanack – a collection of Munger’s talks and speeches –is worth reading if you’d like valuable investment insights without mathematical models. The best description of Poor Charlie’s Almanack is it is a compilation of uncommon sense and brilliant insights with logical simplicity.

A Recent Market Look Back

After three months of declines, stocks saw a broad-based bounce back in November and December. The reasoning appears to be mostly related to a continuing moderation of inflation, along with the belief that central banks are done raising interest rates and in fact, may be heading to cuts. Not surprisingly, the Magnificent 7 (Apple, Google, Microsoft, Amazon, Meta, Nvidia, and Tesla) led the rally

As of this writing, 1.25% of rate cuts are expected by Fed funds futures traders by the end of 2024. The yield on the 10-year Treasury has also declined significantly, from 5.00% at the end of October to 4.00%. This reflects some growing worries about the strength of the global economy that has caused bonds to rally, and stocks have followed suit. There are also some signs that the labor market is weakening, as continuing unemployment claims are now at the second highest level since November 2021. Plus, private sector job growth is now 130,000 versus the 2022 monthly average of 376,000.

Impact to Interest Rates

But in the longer run, many other factors will contribute to the future level of interest rates. The massive amount of public debt must be financed by an ever-growing increase in the issuance of Treasuries, which now have fewer buyers than they used to. And paradoxically, if the labor market continues to soften, it’s highly likely that budget deficits will expand even more to fund-growing unemployment claims and expansion of government benefits. As Treasury issuance (supply of bonds) grows, it will put upward pressure on interest rates.

Right now, with a growing economy and full employment, the Federal government is running a $2 trillion annual budget deficit. Interest expense alone on the existing debt will be around $745 billion for fiscal 2024 according to the Congressional Budget Office, which is on par with the Department of Defense budget. High debt levels are a risk and have a negative impact on the economy and markets.

Central bankers may be hesitant to cut rates absent any meaningful slowdown in the economy because the current high levels of fiscal stimulus is inflationary. The Fed went all-in when it came to easing monetary policy in response to COVID-19 but were very slow to reverse course, which is partly behind the 2022 40-year inflation high. Despite inflation now being down, the battle is still not over. Keeping it down will be a challenge. We still face inflationary pressure from deglobalization, wars, trade friction, poor health of the labor force, demography, environmental policy, government spending, and crime. Therefore, it’s possible that stock prices – especially among the most popular stocks – are ahead of themselves at this point.

Understanding Financial Conditions

Probably the most important chart to explain stock prices in 2023 is this one:

This shows the financial conditions index for the last two years and, as you can see, financial conditions have loosened throughout 2023 to a new high – despite some bumps along the way. What does financial conditions measure? Broadly speaking, financial conditions measures stress in financial markets. It’s an amalgamation of things, such as equity prices, interest rates, credit spreads, the US dollar, price volatility, and other variables. Loose financial conditions indicate low stress.

The thing about financial conditions, however, is that it has limited predictive value and can change on a dime. Any upside surprise in the inflation statistics, downside surprise in employment numbers, geopolitical or credit events can cause conditions to tighten quickly. Tightening conditions can have a negative impact on markets.

Had we known with certainty a year ago that financial conditions would ease significantly in 2023, (despite rising interest rates and tight monetary policy), we, of course, would have positioned differently. In fact, we probably we would have loaded up on speculative stocks.

That said, it would have been imprudent for us to do so because the valuations of speculative stocks are still astronomically high relative to sales and earnings, and valuations do matter. We will not play musical chairs with our clients’ money. We know that we do not know the future, and the future is often very different than what we think it will be.

Even though stocks were generally up, returns were bifurcated in 2023 between the cultish Magnificent 7 stocks, which are up a lot, and everything else, which are only up slightly. Stocks are broadly only back to where they were two years ago. And it didn’t matter if you were in growth or value stocks over that two-year period. Value stocks were down a little in 2022 and up a little in 2023. Growth stocks were down a lot in 2022 and up a lot in 2023. For the most part stocks are right back to where they started in December 2021 in both styles. Even the Magnificent 7 are mostly back to where they were at the end of 2021. In 2022 they were down 40% – 70%, and in 2023 they were up 50% – 230%. Same same.

The Magnificent 7 are similar to what was referred to as the ‘Nifty Fifty’ in the 1970s, which were stocks of large dominant companies and top-index constituents. Then, it was thought that they could be bought without regard to price – ‘price’ being the relationship of the stock price to sales and earnings of the company. That proved not to be true and the Nifty Fifty stocks ended up being poor investments.

We have continued to not own the Magnificent 7 simply because they do not present great values in relation to profitability and their likely future growth rates. And owning things that are wildly popular at the moment and trade at expensive levels, (see above price-to-earnings ratios) has proven to be a losing strategy for long-term investors time and time again.

The more recent decline in rates along with a stock rally reflects increasing hopes that the Federal Reserve will be much more accommodative going forward, but even if it is, that is not necessarily super bullish for growth stocks, (which have already rallied). Any cut in rates from here will likely be modest because of the aforementioned inflation pressure, and those rate cuts would likely be in response to an economic slowdown or recession.

The other thing people have forgotten is that Fed policy (with increasing interest rates) acts with a 12- to 18-month lag. Actually, it may be a longer lag because when rates were super-low, most people and businesses refinanced debt at low levels and the re-financing cycle hasn’t kicked in. So, the economic effect of increasing rates has not been seen yet because the effective Fed Funds rate in July of 2022 (18 months ago) was 1.7%.

If we are indeed at the end of an era of easy money, stock valuations will matter a lot. Investors and traders will be much more discerning and rational in how and where they invest their capital. Today’s speculative euphoria will likely fade and capital should come back to companies that are making money and that have valuable, enduring assets.

Applying Munger’s Learnings for the Long Term

It is important to remember that investing is interpretive. Two different people can look at the same set of data and form completely different perspectives. Being interpretive is what makes investing more art than science. Two investors may also have completely different motivations. One might be long-term oriented and trying to protect clients from big risks like high valuations, and one might not care about risk at all because he/she is paid for short-term returns. This is why it is impossible to predict how human beings will interpret and react to future data, let alone what that data will be. The best a long-term investor can do is to own good risks and avoid bad ones. Charlie Munger understood this.

Munger said, “It is remarkable how much long-term advantage people like us have gotten by trying to be consistently not stupid, instead of trying to be very intelligent.” Buffett said, “Rule Number 1 is don’t lose money. Rule Number 2 is don’t forget Rule Number 1.” They weren’t talking about normal price variability; they were talking about suffering a permanent loss of capital, which comes from overpaying.

Here at Townsend, we have spent a lot of time on our investments and believe we own good long-term risks with high upside and low downside. From year to year, we can’t know how other people will feel about them or how they will be priced but all possess ingredients for higher prices, later. We try to apply the lessons of Buffett and Munger and, while we probably won’t earn the 2,000,000% (20,000:1) return that Berkshire has over its 58-year tenure, we believe that we can at least help you earn high returns without exposing you to the risks that so many other investors are making today.

If we can answer any specific questions about what is happening in the market and what that might mean for you, please don’t hesitate to reach us.

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“The stock market is a device for transferring money from the impatient to the patient.”

– Howard Marks

By John Goltermann, CFA, CGMA

Some of the recent developments in markets conflict with each other and are worth examining. Crude oil prices have rallied strongly despite softening global economic data. Stock prices have remained buoyant despite rapidly rising interest rates over the last 3 months, (from 3.75% to 4.25% on the 10-year Treasury and from 6.5% to 7.2% on mortgages). Inflation has remained sticky despite the Fed’s efforts to control it.

There are distinctive reasons for all these crosscurrents. For example, the rise of crude oil prices has resulted from supply challenges due to policy decisions, geopolitics, and production issues. Energy prices affect the price of just about everything that is physically produced and delivered, so inflation has persisted. Stock market liquidity has remained strong because financial conditions have continued to ease in the face of rising rates, which in turn have kept stock prices up. Interestingly, the rally in the S&P 500 through the first half of the year was limited, mostly, to a handful of large tech stocks that have generally been flat since June.

Stock price volatility has declined overall in the last quarter as investors, in aggregate, appear to be anticipating a so-called “soft landing” in the economy. A soft landing would mean continuing economic growth and declining inflation. This remains to be seen.

Making accurate predictions from past performance is a myth

One of the investment lessons I learned early in my career is that past returns do not predict future returns. In fact, the most recent returns often predict the opposite return over longer periods of time. This is a reality that the investment industry generally does not talk about.

If past returns predicted future returns, Beyond Meat, Lyft, Teledoc, Zoom and Peloton would probably be worth around 100 times more than they are today, instead of being down significantly from their highs. The Janus Global Technology Fund would be up 10,000-fold after its tripling in 1999 instead of being down 80% over the ensuing 18 months and trading at a loss for 20 years after its year 2000 net asset value. Excitement and return-chasing (buying stocks whose prices have recently risen) is common behavior among both individual and institutional investors, but it does not work. It is important to be skeptical of today’s winners because they can be the worst investments.

Some stock prices are driven higher for no good reasons other than hype, career risk, and herd behavior. Many professional investors fear not owning hot stocks and, God forbid, underperforming a benchmark. Accordingly, their decisions often have nothing to do with the quality of a prospective investment, its long-term prospects, or the value of the business itself. In the short run, the price of an investment reflects human emotion, behavior, incentives, and biases. And we humans are fickle. But for those investors who are able to have a long view and use time to their advantage, these mispricings create risk and opportunity.

A 90’s bubble examination

I remember the late 1990s when Sun Microsystems and Cisco were the “hot stocks”. Professional money managers “had to” own them because they were large index constituents, and if you didn’t own them and your performance lagged in a rising market, you might lose business. Today, money managers “have to” own Nvidia, Apple, Google, etc. because there is little tolerance for “underperforming.” So those stocks are widely held, trade at very high prices and carry significant risk. Moreover, money pouring into the S&P 500 drives the prices of its largest constituents higher, but that capital is largely invested without regard to risk or price. In my opinion, realistic values of those businesses do not support their current stock prices.

Sun Microsystems and Cisco were on the forefront of technology development in the late 1990s -they were spoken of constantly on CNBC (and other financial media) and had performed spectacularly. Everybody talked about them all the time. But precisely at the peak of their popularity, they were terrible investments. Unfortunately, that is often how markets work.

A feature of every bubble is that many investors lose touch with reality. This environment is no different. Take the unprofitable Vietnamese electric vehicle maker, Vinfast Auto, as an example. In August, the company was valued by markets at $200 billion -more than Boeing Goldman Sachs; and GM and Ford combined. VinFast had produced 19,000 cars at a loss. This type of delusional pricing based on hype is commonly seen in bubbles, and, in VinFast’s case, it is a product of very few shares being publicly available, combined with institutional ESG mandates,(socially responsible investing) and a clamor for any investment that checks ESGboxes.

Contrary to renowned strategists such as Jeremy Grantham, I do not believe that there is a bubble in everything. Gold mining stocks, for example, trade at depressed prices relative to their likely value. Many stocks, in fact, trade at attractive levels. But the so-called ‘Magnificent Eight’ stocks trade at extremely high levels relative to their profitability and a realistic estimate of their future growth. The point is this: Wall Street promoters are still able to whip up performance-chasing behavior that, in turn, runs up the prices of more speculative investments to unrealistic levels.

Complacency in high-rate environments is not advised

Going forward, we still must invest in an environment of much higher interest rates but one where many assets still carry the prices created by a low-rate environment. And in one of the most important crosscurrents and ironies of all, the Federal Reserve is combating inflation while Congress itself is contributing to it through record spending and fiscal deficits, (see chart below). In fact, fiscal spending is higher now than it was after the great financial crisis of 2008.

Considering these reasons, it makes sense to stick with reasonably-priced investments and to avoid excessive risk. Risk comes with too high prices. We also look for solid fundamentals–good quality assets, manageable debt, and strong corporate governance. With Townsend, our goal is to earn you high returns on your investment dollars while avoiding large losses that can come from overpaying. Large losses significantly lower your average return. Investors who chase returns and don’t care about the prices find this out the hard way.

That said, we invest in public markets where prices are set by other investors and speculators. No matter how well we do our analysis, price declines are an inevitable and normal part of the investing experience. This is also true for bonds, which is why we have kept maturities mostly short and quality high.

The team at Townsend Retirement thanks you for your trust and your referrals. Protecting the financial well-being of our clients is the essence of our business. We promise to work hard to make good decisions on your behalf and we encourage you to speak to your advisor if you have any questions about investments, personal finances, or anything else.

We look forward to hearing from you soon.

“Investing is a popularity contest, and the most dangerous thing is to buy something at the peak of its popularity. At that point, all favorable facts and opinions are already factored into its price, and no new buyers are left to emerge.” 

– Howard Marks

By John Goltermann, CFA, CGMA

Investors could really increase their chances for success by applying lessons from some of the best investors of all time. Howard Marks is one of them. Charlie Munger, Stan Druckenmiller, Warren Buffett and Seth Klarman are a few of the others. Two common themes emerge from their observations about successful investing:

1. The importance of temperament
2. The ability to be skeptical of what the “crowd” is doing.

Howard Marks stated it best when he said, “You can’t do the same things others do and expect to outperform.” Included at the end of this piece are more of Marks’ notable quotes.

It has been a quiet summer so far. Apart from Fitch’s downgrade of US government debt and Moody’s downgrade of a big chunk of the banking sector, it has been mostly drama-free. However, these developments do highlight more significant long-term issues. Stock prices have drifted higher over the last few months but during the month of June, the rally broadened out from its narrow leadership of mega-cap tech companies to include most stocks. The equally-weighted S&P 500 is now up around 9% since May 31.

Interestingly, this happened amidst rising interest rates. The 10-year treasury yields traded up from 3.65% on May 31 to 4.21% as of this writing (August 14). Ordinarily, rising rates are bad for stocks but financial conditions have eased,(see below and note: a declining line depicts easing conditions). Factors that can ease financial conditions include rising stock prices, rising home prices, declining interest rates, tightening bond spreads (yields over Treasuries), declining dollar, and declining energy prices.

Two beliefs on what’s ahead

Financial conditions are interesting for explanation but have limited predictive use. For the future, there are two primary schools of thought on how things will go. One is the belief that the economy currently has all the elements and signals to pull off a soft landing. This is what the consensus now believes and has mostly priced in. The other school believes that the soft-landing scenario is a lower probability than what is currently expected and that recessions are unpredictable. In fact, recessions and difficult markets tend to hit right at the moment the consensus believes they are not coming. This happens to be what I believe.

Look out, not down

There is no way to know for sure; everyone is out there guessing. Market prices do not move in a straight line. Traders react to headlines and those reactions cause follow-on reactions. What we do know is that debt levels are high and probably due to interest rates, (the cost of credit)being suppressed by the Fed for a long time. We know that interest rates has risen significantly. We know that COVID policies caused dislocations. We know that many institutional investors are restricted from investing in traditional energy sources. We know that technology stocks have dominated returns over the last 14 years and now comprise 38% of the S&P 500. We know that markets eventually revert to the mean. We also know that the same eight Wall Street darlings of the last 10 years, (Microsoft, Apple, Google, Amazon, Facebook, Tesla, Nvidia, and Netflix) have outperformed everything this year and trade at valuations that imply massive profit growth for a very long period of time. We can take these observations and begin to form an investment strategy using time to our advantage.

A late stage – not new – bull market

Because the same eight stocks skyrocketed this year using ‘AI’ as justification, it tells me that it is possible that we are still in the late stages of a 14-year bull market and last year’s decline was a simple correction. New bull markets usually see different leadership. Apple is now down 10% from its recent high, Nvidia is down 12% and Tesla is down 18%. Some of the froth seems to be coming off in the more speculative stocks. What never made sense to me was this year’s massive stock price rally because it did not tie to improving operating results. Revenues have been flat to down over the last few quarters. The runup in the Magnificent 8 was largely due to multiple expansion and “forward looking statements” not actual results. But lots of things in markets do not make sense.

Prioritize longer-term value over rapid growth

What does this mean? A cautious approach using a value-oriented investment process is still in order. Financial conditions can deteriorate quickly and rampant speculation by leveraged traders abates when they do. We do believe we are in the early stages of a long period when a value approach to stock investing will outperform a momentum based or growth-oriented approach simply because of mean reversion and the expectations implied by the prices of today’s tech stocks are overly optimistic.

It is important to remember that drama free periods are interrupted by drama filled periods. Low volatility predicts high volatility. This is not a reason to change tack or do something different – it is just to mentally prepare for times when conditions change, and if scary headlines start coming in. During those times it is important to take pause to consider what is happening, what it might mean and what to own on the other side of it. Owning good claims on valuable businesses that are well-priced is the best protection from having to do anything rash when conditions change. The people who own high-flying and popular stocks can worry about that.

Additional Investment Wisdom from Howard Marks

“The safest and most potentially profitable thing is to buy something when no one likes it.”

“To beat the market, you must hold an idiosyncratic and non-consensus view.”

“Not only should the lonely and uncomfortable position be tolerated, it should be celebrated.”

“Investment risk comes primarily from too high prices, and too high prices often come from excessive optimism and inadequate skepticism and risk aversion.”

“For investing to be reliably successful, an accurate estimate of intrinsic value is the indispensable starting point. Without it, any hope for consistent success as an investor is just that: hope.”

“The difference between successful people and really successful people is that really successful people say no to almost everything.”

“Investment success doesn’t come from ‘buying good things’, but rather from ‘buying things well’.”

“I like to say, ‘Experience is what you got when you didn’t get what you wanted’.”

“When you boil it all down, it’s the investor’s job to intelligently bear risk for profit. Doing it well is what separates the best from the rest.”

“Many of the great financial disaster we’ve seen have been failures to foresee and manage risk.”

The truth is, the herd is wrong about risk at least as often as it is about return.”

“The possibility of permanent loss is the risk I worry about.”

“Nothing goes in one direction forever. Cycles always prevail eventually. Just about everything is cyclical.”

Can a measurement of time be defined here? Is this true over the past 10 years?