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Q2 2022 Quarterly Letter

How Biases Shape Market Movements  — and Create Opportunities

“The idea that the future is unpredictable is undermined every day by the ease with which the past is explained.”

             Daniel Kahneman “Thinking, Fast and Slow” (2011)

One of my favorite books about investing isn’t about markets – Daniel Kahneman’s “Thinking, Fast and Slow” explains how we as humans evolved to make decisions in two ways: instinctively and emotionally, or logically and deliberatively.  The book taught me the importance of how people’s biases shape market movements and create opportunities.

Kahneman’s quote captures the essence of today’s markets.  Investors are looking at 2022’s abundance of data points that resemble near-term and long-ago history and are starting to draw conclusions about the future.  What are these conclusions?  The most worried investors are gravitating to the facts that resemble prior stressful periods, especially for inflation and the housing market.  May’s Consumer Price Index reading of 8.6%[1], the highest reading in four decades, prompted worries about a return to 1970s-style stagflation.  Other investors saw recent home prices of more than 20% year-over-year and drew parallels to the global financial crisis, which began with speculation in US residential real estate.  Historical events like these remain vivid reminders for these investors to stay cautious.

Investors taking stock of other more constructive data points can make the case that both stagflation and a housing crisis seem unlikely.  Evidence includes the strength of the consumer, the tightness in the labor market, and a lack of supply in the housing market.  Except for a few months following the onset of Covid, consumers have never spent less of their incomes servicing debt; just 9.5% of a typical household’s disposable income goes to paying debts[2] leaving consumers well insulated from rising prices.  Consumers are also supported by a strong labor market, where an unemployment rate of 3.6% is underpinned by two job openings for every job seeker[3]. The bottom line is that stagflation and financial crisis are unlikely when consumers are flush with cash and have seldom had an easier time finding employment. 

Despite the consumer’s strength, the economy may enter a recession in the period ahead. Discounting the future, the stock market has already responded to this risk, with the S&P 500 falling as much as 23% from its peak[4]. A drop of this magnitude is on par with the typical recessionary decline for American stocks, looking at the 12 recessions that have happened in the post-war period; only recessions associated with unusual economic risks exceed that level significantly.

Bloomberg and the National Bureau of Economic Research

Investment professionals often discuss what information has already been “priced in” by the market.  This is an example of Kahneman’s thinking slow – taking a deliberative approach to understanding what stock prices tell us about the future.  Most of the time, the market is good at pricing in the future rather than dwelling on the past.  With the stock market already down as much as it would be in a typical recession, it is fair to say that investors have already priced in an economic decline.  While we shouldn’t necessarily stop worrying about a recession, there probably isn’t an opportunity to reap an extraordinary profit by betting against stocks today.
Unlike stock investors, bond investors appear to still be trading on past data and haven’t embraced the current opportunity.  2022 handed bond investors an out-of-character loss on the back of a sharp rise in interest rates and a four-decade high in inflation.  Bond investors appear to be startled, scared, and thinking fast.  We believe they are responding to what just happened rather than anticipating the future. If a recession approaches, it will likely subdue inflation to more comfortable levels and leave today’s interest rates looking very attractive.  One opportunity, intermediate-term corporate bonds, sport their highest yields since 2010[5], allowing intrepid investors the chance to lock in higher incomes.
We are responding to this year’s risks and opportunities by continuing to do what has worked with stocks and taking a different approach with bonds.
– In stock portfolios, we believe attractive valuations and expected growth will be supportive for investments in value segments of the market, smaller companies, and real estate. 
– In bond portfolios, we’ve increased our allocation to investment grade bonds, taking advantage of some of the highest yields available to investors in 12 years.
2022 will likely continue to be a turbulent year with sharp changes in the fortunes of different market segments.  While markets will remain unpredictable, we will seek to respond to the opportunities by rebalancing portfolios using market declines as an opportunity to put cash to work at bargain prices, using volatility to reduce taxes owed by harvesting capital losses and reallocating as markets overact to uncertainty.
[1] source: Bureau of Labor Statistics
[2] source: Federal Reserve
[3] source: Bureau of Labor Statistics
[4] source: Bloomberg
[5] as measured by the BofA Corporate Bond Index

Important disclosure information

Please remember that different types of investments involve varying degrees of risk, including the loss of money invested. Past performance may not be indicative of future results. Therefore, it should not be assumed that future performance of any specific investment or investment strategy, including the investments or investment strategies recommended or undertaken by RegentAtlantic Capital, LLC (“RegentAtlantic”) will be profitable.

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