The year 2021 was mostly a Quad 2 year. For those of you unfamiliar with our terminology, that’s when Growth and Inflation are both accelerating. The economy does well under these conditions and stocks love it. So that’s why 2021 was a good year for almost all kinds of stocks including small-cap stocks, junky stocks, energy, and commodities. But that’s over now because the economic cycle is not static, quite the opposite, it constantly changes. During November, our models began detecting a deterioration of small-cap stocks. As is generally the case, this deterioration occurs beneath the surface and goes unseen by the masses. This deterioration spread to include mid-cap stocks and is now bleeding into large-cap stocks. Many years ago I began to call this sequence a Major Market Topping Process (MMT). This sequence was observed back in 2007, the second half of 2015, partially in late 2018, and now. The difference between now and those instances was that there was no real inflation to speak of. This time could be a real game-changer depending upon what action the Federal Reserve takes to address inflation, interest rates, and the government’s need to fund its huge spending. Concurrent with this MMT was our models beginning to hint at a possible oncoming Quad 4 in the second quarter of 2022. You may recall that this is the economic regime when Growth slows and Inflation slows. Since November as the economic data and market signals began confirming our models, it is now a virtual certainty that this will be the outcome for 2Q 2022. How long Quad 4 will last beyond the second quarter is difficult to say right now.
Unfortunately, many on Wall Street think the recent market turbulence is part Russia and part US Federal Reserve. I disagree. Our focus here at Lifelong is to monitor the rate-of-change of growth and inflation. By sticking to this discipline we can ignore all the noise related to politics, Russia, and whatever the Federal Reserve will or will not do. The fact is, the cycle will slow and the financial markets will adjust accordingly. Even if the Russia situation ended today, we would still keep doing what we’re doing. Therefore, our process requires that we adjust our portfolio allocation to reflect this reality. I also want you to know that during a Quad 4 economic regime….bad things always seem to happen. During periods of growth accelerating…financial warts and geopolitics almost always seem to get covered over until the moment when growth begins to recede and then all financial warts become a problem that everyone begins talking about. Warren Buffet has a saying that is related to this: “when the tide goes out, you get to see who is not wearing a bathing suit”. As of right now, most investors are not wearing a bathing suit. They think this roughly 12% decline in stocks is just another short-term blip. I wish them well.
Now let’s review the portfolio changes Lifelong has made to client accounts. During the last two weeks of December, our market signals revealed that investors had become very complacent and were overloaded with stocks. How did we know this? Bear with me as I geek out on you for a moment. We created a mathematical model that measures what we call Implied Volatility Premiums and Discounts. There were steep Discounts all over the place and they are an indication of investor complacency. Given the oncoming Quad 4 we were expecting, we began to actively sell stocks and got highly defensive in the face of this complacency. Highly defensive means we substantially raised our cash position by selling almost all of our stocks. In January we slowly began to use some cash to transition into minimum position sizes of US Treasury Notes and Bonds, Gold, and the US Dollar. Consumer Staple stocks and Utilities usually work in Quad 4 too. However, during periods of high volatility, they can also go down. So we have to handle these two sectors with a bit of extra care. We were a few weeks early with our Treasury Bond allocation in January but that seems to be behind us now. And, we believe that as Quad 4 unfolds in earnest in the coming weeks and it becomes more obvious to investors that the economic cycle is actually slowing, Treasury Bonds will become the safe haven they have always been during a Quad 4 economy.
You may not know this but it has been reported that January 2022 was the worst January ever for stocks. February hasn’t been much better. The portfolio changes Lifelong began implementing in December and January were the right steps to take because we were protected from that 10% decline. I’m writing this note on February 27th and as economic conditions continue to deteriorate in the coming weeks and months, you can be assured that we are prepared to take whatever steps are necessary to preserve and protect our hard-earned money. I have a saying about our investment process: “we skate to where the puck is going to go”. This simply means that as our economic models and market signals detect changes, we begin to slowly adjust our investment positions for what is coming next. That’s exactly what we started doing in December.
Please feel free to contact me with any questions.
Please feel free to contact me if you would like to learn more about our strategy.