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Value Investing: How to Invest In Uncertain Times

What should you do during uncertain times for value investing?  The stock market has sold off more than 20% since January highs.  The Nasdaq is down some 26% since its recent peak.  This firmly establishes that stocks are in bear market territory.  And, the selling has been consistent and forceful.  Given this, how does a value investor navigate uncertain times?

One thing to keep in mind is that over the past several years, and especially since the March 2020 COVID-induced lockdowns, the stock market has gone upward in an almost unabated straight line.  Unfortunately, some have grown so accustomed to the constant movement upward that these individuals believe that going up in perpetuity is what is natural.  Markets do not always move like this.

Instead, markets spend more time oscillating up and down and move upward in a more gradual method.  This will make investing more challenging.

To be sure, the excessive income increases from the stimulus checks, the massive liquidity injections by the Federal Reserve, and the rebound in the economy, are going to be shifting.  There is simply too much inflation from demand pull inflation.  And, now that the party has been rolling as long as it has, the Federal Reserve is stepping in to take away the punch bowl.  The economy will shift from this.  Normal, steady, constant increases in investment balances, once a daily staple, are going to be scarce.

What to do as a value investor in uncertain times

S&P 500 Chart - Value Investing During Uncertain Times

Be patient would be my first bit of advice here.  There will always be investment opportunities.  But, being patient is a pragmatic approach.  If the economy does enter into a full-blown recession as the Federal Reserve tries to reign in inflation, recovering to market highs may take some time.  And, stocks may continue to sell further.

During the DotCom era, the Nasdaq sold off some 80% of its value.  It would then take 15 years for the market to fully recover those all-time highs.  But, things are different today than they were 21 years ago.  For starters, the Nasdaq valuation was spread out over far, far more stocks.  Now, the FAANG stocks make up such a large portion of the Nasdaq that they outweigh almost all other Nasdaq stocks.

Simply: Do not assume that the market is going to instantly bounce back upward and recover.  It will not (And, I will explain more so below as to why).

But, also balance this into your thinking: The market will very likely not take nearly as long to return to full capacity and begin building up the necessary momentum to overcome recent highs.  However, it may very likely take a few years to do so.

Value Investing & Buy Signals

University of Michigan Consumer Sentiment & Value Investing

One of my favorite indicators for tracking the health of the economy, and its potential future, is consumer sentiment indicators.

Consumer sentiment indicators are an excellent indicator because what they show is how confident consumers feel.  If there is a rising amount of income in the economy, consumers feel more confident about their own future prospects.  They will spend their increasing incomes on an increasing rate.  This drives the economy, and economy that is some 70% consumer driven.

Likewise, if the consumer is concerned about their future prospects, they will contract their expenditures.  This contracts the economy.

The University of Michigan consumer confidence indicator above is showing that there is declining confidence in the future for consumers.  The most important thing to note is that the indicator is pointing downward.  It is not bottoming out and trending sideways with the potential of eventually heading higher.  It is still moving lower.  This means, the economy will continue to contract from here.  And, stocks will follow.

Trading Versus Value Investing

One of the first things that is important to do is establish where you are within the investing process.  A value investor would be in it for the long haul, holding positions for very long timeframes.  But, a trader would be someone who is in it for mere moments, if that is an hour, a day, a week, a month or slightly longer.

In this posting, I am going to focus entirely on value investors.

And, as mentioned, a value investor would consider holdings that they plan on keeping for many years to come.

Consider the bigger picture

While we are seeing some robust economic data such as employment numbers, we are also seeing signs the economy is stretched too thin.  Inflation numbers are far too high for anyone’s liking and, the Federal Reserve is going to take measures to stave off further inflation growth.

But, I do not believe we have seen the entire picture play out with regard to the War in Ukraine.  That means there will be even further inflation gains that the Federal Reserve is going to have to fight against.  If this plays out, there could be far, far more selling in the future in stocks if inflation numbers do not abate.

This is not an economic environment by which to initiate positions.

The Current Economic Disposition

Simply put: There is too much inflation.  Period.  The Federal Reserve will do what it needs to do to contain inflation.  And, what tools does the Fed have at its disposal to combat excessive inflation?

When the COVID lockdowns started, the Federal Reserve ensured that the economy would not sputter out.  They have two very useful tools.  They employed these tools with vigor.

Interest Rate Increases

The Fed lowered interest rates to ultra-low levels to ease any burdens on families and businesses so that more money could be used for expenditures versus paying debts.  This worked.  But, the economy is moving too fast chasing after limited supplies in an environment where the supply chain has not fully recovered from the COVID-induced lockdowns.

Policy Liquidity Removal

The other policy tool the Federal Reserve has at its disposal is Adding liquidity to the economy.  The Federal Reserve created a massive amount of new money with the touch of a button.  They then stepped into the economy and bought US Treasury debt as well as MBS debt and some other instruments.

By creating new money and buying debt instruments, this meant that anyone who would have wanted to buy debt instruments would have had to look elsewhere in order to find debt to invest in since the Fed consumed so much.  This ensured lower interest rates throughout the entire economy.

The Federal Reserve is Reversing Policy

The Federal Reserve is now in the process of reversing policy by raising interest rates as well as allowing debt instruments to fall off without renewing them.

Higher interest rates, or borrowing costs, will mean that both consumers and businesses will have higher borrowing costs to pay.  The end result of this is contracting economic activity.

Consumers

For consumers, this means that any purchases on credit cards are now going to be more expensive.  When you consider the entire amount of credit card debt that Americans collectively now carry, this adds up considerably.  Since incomes have been relatively stagnant to the point of stagflation, this removes a considerable amount of money from potentially buying new items for consumption.  Demand will drop and the economy will contract, if but a small amount.

Fuel Costs

Fuel prices are also much higher, hitting all-time highs not ever seen before.  However, if you start to consider this, most Americans drive a relatively average amount of miles in any given day/week/month/year.  Americans likely contain themselves to a relatively small number of miles away from home and travel in that near area.  But, the price of fuel moved from, say $2.50 per gallon upward to over $5.00.  Americans are still driving relatively the same number of miles.  But, it costs double to do that and, that will mean less disposable income for other kinds of consumption.  This will have the effect of dampening economic growth almost as if it is a tax on the system.

Food Costs

Everyone is noticing that food costs have soared lately, moving upward some 10% for the same items from just one year ago.  Everyone will still eat.  But, consumers are having to get ultra-creative with their limited disposable income in order to meet their needs of getting food.  The extra income being diverted to higher costs of food, despite any level of creativity from individuals, will mean less money being spent on other things.  This will dampen consumption even further especially when you consider the additional costs on life such as fuel and credit card debt.

Rent & Mortgage Increases

The increases in interest rates will trickle through to other aspects of life.  Rent is heading higher and higher at exasperating rates.  And, anyone wanting to buy a home has seen prices that are already out of control become further out of touch simply because the cost of a mortgage is now even higher with increased mortgage rates.

The combination of all of these things means that more money is being spent on things consumers are already consuming.  But, consumers have a finite amount of income.  By spending more on certain things, less will be spent on other, non-essential items.

Value Investing During A Recession

Are we about to enter a recession?  It is very likely.  But, it is not a certainty; it is too early to tell at this point.  With what could potentially occur as a result of the War in Ukraine, we do not know the full amount of what is going on yet.

What is a recession?

The short answer to this is two consecutive quarters of negative growth in GPD.  We have already printed one negative quarter of growth.[1]Bureau of Economic Analysis  The chance of a positive growth rate for Q2 appears to be impossible at this stage.  Then, it may be that there is another quarter beyond that of negative growth before the economy recovers.

How Big Are Recessions?

This becomes the next big question. First, any interest rate increases that the Federal Reserve make take several months before they are fully worked into the economy and start showing up in the economy.

Also keep in mind, the last interest rate increase was a whopping 75-basis points.  And, the next meeting, another 2-day meeting to be held in July, will likely see an additional 75-basis point increase.  Then, there are two more meetings going in to the end of this year that the Federal Reserve are likely to raise interest rates by some 50-basis points each.

This adds up to an additional 175-basis points of interest rates being added to the system.  All the while there will be continued withdrawal of liquidity out of the system.  This will contribute to economic activity contracting on some level.

What to Look For During A Recession

There are a few things an investor should be focusing on that may help determine where the economy is:

Crowd Source the economic temperature

University of Michigan Consumer Sentiment v Personal Incomes & Value InvestingOne of the best indicators to keep track of is consumer confidence. Indicators of which, there are two.  Right now, both consumer confidence indicators are pointing down.  And, they likely have far further to go.

The benefit of watching consumer confidence indicators is that if sentiment does bottom out, the only place to go from there is back up.  If consumers feel confident, they will start spending again.  There is a very strong correlation between consumer confidence indicators and the future trajectory of the economy; the US economy is over 70% driven by consumer consumption.

The best part of this is that consumer confidence numbers are a lagging indicator.  However, the lag is small compared to other indicators.  When consumer indicators start to turn back up, it is time to start betting on the US economy once again.

Unemployment

Employment & Personal IncomesEmployment levels are very robust.  Unemployment levels are very likely to increase as companies start the process of trimming what fat they can from their payrolls.

Unfortunately, changes in unemployment are a lagging indicator (As well as consumer confidence indicators).  But, the lag in unemployment is much larger than other indicators.  This means that while we may be entering a recession on a technical basis, there have been no real substantial movements in unemployment yet.

The reason for this is that employers are not quick to hire/fire employees until there is enough, and a consistent amount, of information to make that determination.

Likewise, once consumer confidence starts to turn up, it may be a while before unemployment indicators start to signal that there are positive developments in unemployment.  Still, once this signal starts to blink, it will be a sure signal to bet on.

Watch Indicators for changes

We are still early in this cycle of the stock selloff.  And, there is likely to be more selling to come.  We may get a small bounce upward but, this will be followed with more selling.

Wait until the signals above show that consumer confidence is starting to mellow out, move sideways, and then start to head back upward again.  That is the time for a value investor to get back in and buy stocks again.

References

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