Up and to the right

One of my great joys over 26 glorious years with Federated Hermes has been the honor of penning these market memos. Freed of the burden of a scheduled weekly economic commentary due to the superb work of Phil Orlando and our macro team, the memo's "as needed" format has allowed me to comment on market conditions at critical junctures, and only when I had something meaningful to contribute. They have been informed by my position as CIO of the equity group, interacting daily with our more than 150 analysts, portfolio managers and traders, and they consider information from my colleagues in our money market and fixed income areas. I’d like to think that the main reason my memos have been popular in the industry is the combination of their free-wheeling, unhindered format and my access to some of the best research on Wall Street.

So, it gives me great solace to know that, after my forthcoming retirement, my successor, Steve Chiavarone, will carry the torch. As my friend and close colleague for more than 20 years, Steve will benefit from the same advantages. He will carry this work to new heights.

These market memos were born during the Great Financial Crisis, when cries of fear and panic filled the airwaves. I felt compelled to counter the deep pessimism I was sure could ruin the retirement plans of many of our clients. And frankly, I can confess I also wrote to help me and my fellow portfolio managers to remain confident in our underlying investment processes, when running for the hills seemed the safer course.

On November 26, 2008, the S&P 500 dropped to 888 — yes, 888, just 10% of today's level. In a commentary that day, I wrote these words to our terrified clients, my anxious portfolio managers, and, yes, myself:

Our research of the six largest financial crises over the last 20 years — Sweden, Mexico, Russia, Thailand, Hong Kong and Japan — shows that markets tend to bottom sometime between "immediately " and 12 months after the bailout announcement [which had just occurred]. And while returns during this bottoming process can be volatile, the average market appreciation in local currency terms from the point of the bailout to three years out was 49%. This is not a forecast, and every financial crisis is different, but the data suggests that the next 12 months present a historically good time to average into equity markets."

That statement proved to be, if anything, too conservative. Within a year, the market had rallied back 25%, though even then remained four years and 41% from finally breaking to new highs and birthing The Great Secular Bull.

As regular readers are aware, not all our calls were accurate, and several were "early." But most were directionally correct. When we were wrong, we took corrective action in a timely fashion. I had learned earlier — the hard way — that "the only thing worse than correcting a mistake too late is correcting it too later."

One of my first projects in the coming months will be to complete my account of initial failures, recoveries, perseverance and ultimately triumph in this incredible enterprise of managing the assets of the millions of people relying on us. My working title: "Humility at the Highs: 45 Years Riding the Bull, Fighting the Bear and Chasing Heaven." Without revealing the stories themselves, I’ve selected five lessons that seem particularly relevant today:

1. Get the framework right. Markets are complicated, multi-dimensional chess games played by some of the smartest people in the world. To process the daily inflow of information, human beings need a framework to organize the facts. Especially in the aftermath of a seismic event that destabilizes or even overturns the chess board, resetting the framework or inventing an entirely new one can mean the difference between success and failure. In the early 2010s, many investors believed in "the new normal" framework, which focused on excessive debt and low growth ahead. They missed out on the early years of the Great Secular Bull. Why? Because they failed to account for the positive psychological impact on decision makers and investors who had simply survived the economic Armageddon of 2008-09, lit up by the barrels of rocket fuel dropped on the markets by the Fed. That combination fueled a multi-year run as things simply got "less worse." Currently, many investors, particularly traditionally trained economists, are using an outdated, rearview mirror approach to projecting Federal Reserve policy. It is one that assumes economic growth and inflationary pressures are causally related. They fail to see that supply-side reforms and the AI boom are boosting productivity that will grow the economy and earnings without requiring rate hikes. Their view is hobbled by the wrong framework.
2. Stocks eat nominal earnings. Most economists and market strategists are trained to analyze "real returns," that is, returns net of inflation. While interesting, the reality is these are highly theoretical and often difficult to calculate. It is even tricky to decide which of the six or seven inflation measures should be used in the calculation. In the real world economy in which stocks live, companies produce nominal sales and nominal earnings, and stock prices are set nominally. Until 2020, inflation was running below 2% and this differential framework didn't matter. But now it does. With nominal earnings exploding higher of late (and projected to rise above $450 by 2028), stock prices are being carried along for the ride. Investors focused on "real earnings" have been left on the sidelines.
3. Focus on the forward market, not the spot market. Different investors have different time horizons. At the very short end, day traders, algorithms and Wall Street prop desks try to make money on every tick on the tape. They are focused on minute-by-minute news for sharp, short-lasting moves. Hedge funds often play in this quarter, reading management's body language at every conference while scraping real-time data sets. Longer-term investors, such as Federated Hermes, assess a company's two-to-three year growth trajectory based on its management team, market position, balance sheet and competitive position. Historically, this diversity of time horizons has been well-balanced. But of late, trading flows have increasingly tilted toward the day traders and hedge funds — "the spot market." While this can create disconcertingly volatile price moves, longer-term investors are presented with unprecedented opportunity to arbitrage the increasingly wide gap between what I call the spot market and the forward market. Understanding this arbitrage is one of the great opportunities in today's environment, and a tenet of our investment teams.
4. Doing nothing is often best. Especially in today's 24-hour news cycle, every bit of new information is viewed as monumental, requiring an immediate response. Even long-term investors can be swept up in the turbulent waters. They adjust their portfolio positions repeatedly, and sometimes in opposite directions, as news breaks, is reversed and then swings back. But just because a headline screams out "Do something!" doesn't mean that something needs to be done. It might feel better to act. But in my experience, provided that your original position was established on a solid research foundation, the best response is often to sit tight. Ask any investor in chip stocks over the last three months.
5. The line moves up and to the right. The stock market is not really as complicated as it seems. At the end of the day, equity investors own a share in the global economy, and that economy inexorably grinds higher, even through setbacks and recessions. Population growth, productivity expansion, returns on invested capital and, yes, inflation, interact to grow the proverbial pie. And as that expands, a curated basket of diversified companies that participate can also grow over time. Historically, that is the line that moves up and to the right. I say don't fight it. Ride it.

Some of you may be wondering about the last words of my memoir’s working title, "Chasing Heaven." That refers to the world beyond, for which, in my opinion, we all yearn even if we don’t realize it. To me, the market lessons proffered above have a spiritual analog, which took me too long to fully understand (and in some cases, I have yet to). As they say in the publishing business: "details to follow."

Thank you for your loyal readership and support through thick and thin. It's been a wonderful ride together. 

May your line keep moving up and to the right.