Understanding Current Market Volatility

Breakwater Team • September 24, 2022

Yuck… some of you may feel compelled to swap out the first letter of the word I’ve chosen to describe the month of September, or frankly all of 2022 to this point. If you feel like you just got out of the ring with Muhammad Ali (circa the Sonny Liston days) you are not alone. With a little over three months to go before the calendar flips over, 2022 may very well go down as one of the worst years for the markets going back to the 1930s. Narrowing the field of vision to the start of this century, only 2008, during the Great Financial Crisis when the market declined 37% and 2002, where the aftermath of the bursting of the dot com bubble was compounded by the tragic events of 9/11 leading the S&P 500 to shed 22% then. As of the close of trading on September 23rd, the market is down 21.6%, so just a hair from taking over the number 2 spot, and for many this feels far worse. Whether it’s the fact that diversification this year has provided no real cushion (the bond market is down over 12%, it’s worst year on record) as has been the case in the past, the seemingly endless daily volatility or that many investors were broadly over-exposed to stocks after a long bull market, especially some of the high beta growth stocks that were highfliers in the early days of the pandemic market euphoria, the pain has been acutely felt everywhere. From time to time I’ll informally survey clients to get a pulse on their feelings, I would not be exaggerating when I say that for many this feels like perhaps their worst year in their experience. The breathtaking declines over the 5-week span in February-March of 2020 when the market dived 35% or Black Monday’s 22.6% drop which had been proceeded by a 4.6% drop the Friday prior were so swift that an investor wasn’t even able to formulate a strategy before it was all over. Those two years somehow managed to end the year in the black, very hard to fathom us being so fortunate today.

So what is going on… You can attribute the market weakness to several factors, some of which I’ll expand on below, though in the end much of it boils down to the fact there is a significant amount of short-term uncertainty and a crisis of confidence.

Higher rates mean lower valuations
Connally’s famous quote, “the dollar is our currency, but it’s your problem”
Geopolitical developments, by now we all understand the war in Ukraine has wreaked havoc on European energy markets likely leading to a pretty significant recession on the continent while in the Far East, the Chinese continue to embrace a draconian lockdown policy to limit Covid’s spread. The Iran Nuclear deal, an election in Brazil and the return of Reaganomics in the UK are other notable matters, but this list is hardly exhaustive
Quantitative tightening accelerates
The prospect of an imminent earnings decline meaning current estimates are too high thus a further correction may be needed to support valuations

Rather than unpack each of the points and sure you could probably throw others into the fold (domestic policy/politics to name one) I’ll address a few of them in depth and spare you where I think your exposure to the subject matter has more than reached its saturation point. Here is an anecdote along those lines. In speaking with my father this past week, and I am paraphrasing here, but he referenced how the Fed’s announcement and Powell’s presser represented somewhat of a must-see television event. Keep in mind that while my father is a worldly character and astute investor, our conversations rarely wander into the topic of interest rate policy. In reflecting on that comment, I found myself somewhat alarmed by the fact that there is far too much focus on short term headlines many of which are only modestly relevant to one’s long-term investment objectives. When we find ourselves obsessing over every detail of a single data point, at a point in time, we are bound to lose sight of the bigger picture, hopefully this note helps with re-anchoring our investment expectations as we persevere through this rough patch.

1. Valuations & Earnings: Stocks have rerated from a multiple of 21 when we entered the year to about 15.5 according to current FactSet estimates, with this being the result of a collapse in P(rice) while E(arnings) have held up. Chalk up the latter to a resilient consumer and nimble and efficient corporations , the question of how sustainable this phenomenon is we’ll return to in a moment. When real interest rates were negative you could essentially pay anything for a company and end up ahead, so long as they had some earnings, which is perplexing why stocks that have yet to actual earn anything or will ever in the future commanded such high prices, but now with real yields positive and mid-single digit returns available in the investment grade debt market nosebleed valuations cannot be justified. There is a simple formula to arrive at the P/E for the market, yes it’s an oversimplification but helpful nonetheless. When taking the number 20, and subtracting the rate of inflation you could arrive at a reasonable P/E for stocks. Using the Fed’s 2% target meant 18X was not out of the question, even if it was higher than the long run average of 16X over the last 100 years or so. With inflation now at 8.3% according to CPI that would mean the market should be trading at less than 12X or about 20% less than it is today. I am not predicting that type of further rerating just sharing one perspective. Assuming inflation starts to trend back down to the 3-4% territory over the next 12-18 months, you are still looking at equities that are around fair value versus a screaming buy, which is where we were after the most recent large sell offs in 2020 and Q’4 2018. That math assumes earnings hold up, if not even grow modestly over the next few quarters (the consensus is still calling for 3.2% growth in Q’3 earnings which we’ll start to hear in another 2-3 weeks.) The issue is that if earnings deteriorate, prices have further to fall. With the Fed calling for an unemployment rate to rise to 4.4% in 2023 & 2024 (I would describe this optimistic view as a soft landing) we are taking about 1.4MM Americans losing their jobs not to mention the limited spending power of our allies in Europe or in other parts of the globe. If earnings decline by 10%, then we are probably okay here, but if earnings follow their typical path in a recession and drop by around 25-30% it stands to reason that prices would need to go lower to support this multiple. This is why you have seen a number of the big Wall Street firms lowering their year end estimates for the S&P, for example David Kostin at Goldman clipped their figure to 3600 earlier this week.

Below is the link to Factset’s piece from yesterday which is chockfull of insightful data on earnings

2. If you converted your dollars to pound sterling right now, you’d actually feel a little wealthier than you did when opining about your New Year’s resolution back in January. There has been an important development that has not received nearly as much attention as warranted, the meteoric rise of the dollar against much of the currency complex. We have seen dollar Euro parity recently, it’s now below the dollar. The UK’s pound sterling is all the way down to $1.04 versus the dollar, I recall when the exchange rate was over $2.00 prior to the GFC and the Japanese Yen is back to levels last seen in the midst of the “Asian Flu” in 1998. Why is this important? Primarily it can exacerbate inflation abroad given that many commodities are dominated in dollars thus adversely affecting countries already impacted by supply chain issues, an energy embargo or the limited access to supply due to geography or as a result of the underinvestment in natural resources over the last decade. Another issue here is due to the fact the dollar is the reserve currency and thus plays significant role in the funding/credit markets. Given the propensity for countries looking to issue greenback denominated debt where interest rates are often much lower than local rates, this could really become a problem over the next 2-3 years as new issuance or refinancing becomes necessary. An alternative view is that perhaps this is a coordinated policy intervention, something of a reverse Plaza Accord when the dollar was devalued back in the mid 1980s. This time the shoe is on the other foot where the weakening of currencies from a number of export driven economies may bolster their competitiveness and jump start their growth, it’s just unlikely to have much of an effect when global growth is declining and a recession seems likely if not inevitable. Maybe this does pay off down the line. There is also the possibility that the Fed’s hawkish stance to slay inflation is providing cover for the central banks across the world that had been using negative interest rates policy to get back into positive territory nominally at least. Clearly ultra-cheap money abroad did not lead to higher growth rates, in some reverse logic maybe higher rates will create a sense of urgency and provide a healthier level of inflation after we get through this current bout.

3. Since last November when the real “Powell Pivot” occurred and comments from the Fed became more hawkish with the forthcoming end to quantitative easing and set the table for raising rates, markets have pricing in higher yields on the short end and we did see some effect on the long end too. Recall the 10-year Treasury started the year at about 1.50% and closed Friday at 3.70% up 220 basis points, a sizable move though not quite historic in an absolute sense. But longer-term rates had stalled out in June until this week’s spike higher. The prior narrative had been that short term rates best express the Fed’s hawkish current policy, if they continued on the current trajectory they were bound to break things leading to a recession and thus slower growth and lower inflation in the future. If that were to be the case then a lower yielding long bond seemed perfectly plausible. Recall that inflation for the 10 years prior to the pandemic averaged just short of 2%, add a little term premium for the duration and you get to a yield between 3-3.50% very much in line with the rangebound trading the last few months. But now with the long end moving higher, is the belief that in fact growth may be a little north of the long run trend given the economic resiliency here in the States ? Or more likely have the bond vigilantes finally taken their shot at the market with a buyers strike right when quantitative tightening ratcheted up this month. With the Fed allowing even more securities to roll off their $9TT balance sheet, a big buyer has stepped away thus sapping about $95BB worth of demand out of the market, $60BB of Treasuries and $35BB of MBS. If stocks were going to struggle to justify valuations with earnings fading, contending with higher rates then becomes further weight to the tape. Just as I am reluctant to attempt to predict the short term direction of the stock market I am going to refrain from sticking my neck out here as well.

So what is an investor to do…

Stick with your asset allocation strategy, if at the margin you want to make adjustments that’s fine but don’t get caught trying to market time. You’ve already taken a good punch, in theory the time to sell was back at the all-time high in January.
For those of you willing to be a bit more opportunistic market dislocations can create opportunities, perhaps you have some money sitting on the sidelines with the intention of investing , it may not be a bad time to put to work slowly, perhaps using a dollar cost averaging approach for the next 3-6 months. With the VIX just shy of 30 there is some palpable fear our there which usually means the market is a bit oversold and bargains can be had.
We all have some cash sitting around likely getting hardly any interest, you can buy 6-month Treasury bills yielding not too far from 4% (3.86% at Friday’s close.) If you don’t mind extending duration, laddering out 6, 12, 18 & 24 month investments likely gets you to 4% on average and if rates do start to go back down in late 2023 or early 2024 you’ll feel a little better having locked in those higher rates for a little longer. If rates keep going up that’s just fine, you’ll have money available to reinvest as the short-term maturities in your ladder come due. Keep in mind for those of high-income tax states Treasuries are exempt from state taxes. There are also some attractive blue chip companies with yields between 4.50-5.00% going out anywhere from 1-3 years and offering a little more if you extend duration 4-6 years out and municipal bonds are starting to look cheap interesting too.
Consider a Roth conversion, with asset prices depressed you are able to convert roughly 125% of the amount of shares you would have back in January, I understand the idea of paying more in taxes may feel like adding insult to injury, but this is likely to pay off if you have a holding period of 10 years or more for the Roth
Rather than wait to fund your Health Savings account or Roth IRA for 2022 up until April 2023 now may be a good time to make those contributions
Harvest tax losses wherever possible, given the market volatility and investor outflows many mutual funds will likely make sizable distributions in the 4th quarter despite the fact the fund lost money this year, this phenomenon is the result of fund managers needing to sell securities to cover client redemptions resulting in the fund realizing gains that had actually occurred over the last 10+ years

Remember markets are discounting systems, they will turn far earlier than the actual economic data seems to suggest. Legendary investor George Soros has talked about the concept of reflexivity and this theory seems rather evident today where price action is having as much influence on markets or economy than the other way around. Quoting Soros, “I can state the core idea in two relatively simple propositions. One is that in situations that have thinking participants, the participants’ view of the world is always partial and distorted. That is the principle of fallibility. The other is that these distorted views can influence the situation to which they relate because false views lead to inappropriate actions. That is the principle of reflexivity.” Perhaps more simply stated markets tend to be dislocated from the equilibrium that defines efficient markets more often than not. This is the result of human beings’ tendency to overshoot assuming that the good days will never end or alternatively that this is the crisis to end all crises and that the sky is truly falling. It’s hard to quantify how much of the selling is a result of the selling and lower prices that have already occurred. It’s not until investors have exhausted themselves with the selling (or buying when exuberance sets in) that markets can drift back towards their real fair value. Along those same lines Nobel Prize winning behavioral economist Richard Thaler has written about the irrationality of the human actors that are everyday market participants in two of his great books “Nudge” and “Misbehaving”. His reasoning is that if the planet were filled with emotionless characters like Star Trek’s Mr. Spock, referred to as “Econs” , markets would likely oscillate a lot less than they do. That seems wonderful right about now, but you’d likely have to forgo the equity risk premium and sacrifice some of that excess return. Stay patient and humble and you’ll be okay in the long run. It’s hardly a perfect system, but it has its advantages and surely better than the alternative systems in place.

Thank you for letting me occupy some of your valuable time!

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The enclosed content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. Nothing contained within constitutes a solicitation, recommendation, endorsement, or offer by Breakwater Capital to buy or sell any securities or other financial instruments or offering in this or in in any other jurisdiction. You alone assume the sole responsibility of evaluating the merits and risks associated with the use of any information contained within before making any decisions based on such information.

Source: Data/Statistics from Factset, Bloomberg, JP Morgan Asset Management

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Breakwater Team

At Breakwater Capital, we work with families across the United States, providing each client with a personalized experience tailored to their current circumstances, future goals, and timelines.

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The naysayers will point out that back then the US accounted for about 50% of global GDP, peak wealth, or about twice what it is today, but that fails to account for the fact that much of the world having fought the theatres of war in both Europe and the Pacific was in ruin and needing to be rebuilt. There is a misconception that both NAFTA (1994) and China’s entry into the World Trade Organization (2001) were the watershed moments leading to the hollowing out of the US’s manufacturing base, but in reality manufacturing employment had been in decline going back to 1950. At its peak US manufacturing workers accounted for about 30-35% of the nonfarm workforce, whereas today that level sits at around 8% where it has hovered for the last 15 years. In 2000 it was just 15% so still very much the minority. This long-term shift in the mix of the US economy where services now account for a disproportionate percentage of GDP and the workforce overall is the result of a far more skilled workforce driving both innovation and productivity. Surely some manufacturing jobs have left based on the focus on corporate profits, but some of the change relates to comparative advantage and inexpensive labor. It’s not to say, that we should look to push all manufacturing to the most “efficient” destination, surely it’s important to maintain control of manufacturing of critical components to defense, information technology or medicine, but it seems unrealistic at best to expect that we can produce enough and at reasonable costs to satisfy our insatiable demand. We are after all only about 5% of the world’s population, though we account for 25% of global GDP. Talk about punching above our weight. Aside from the logistical challenges that reshoring/onshoring pose, not to mention the timeline associated with the payback for such efforts, the willingness or lack thereof on the part of the business and consumers alike beg the question of whether or not it is worth pursuing. Considering our societal tendencies for policy to reverse course every 4-8 years with Washington’s constant changing of the guard which has grown even more partisan in recent years, it’s hard to envision the private sector making these investments where there may be little or no long-term benefit to the majority of stakeholders, mainly consumers and shareholders alike. If we are being intellectually honest, as we have seen with the likes of Amazon, if automation or robotics can do the work better than human beings, who need benefits and breaks, the case for this policy bolstering manufacturing employment seems weak at best. That’s one of the key pillars of the artificial bull case after all. In addition, there is clear evidence that economies which produce a disproportionate amount of goods versus services are much more susceptible to the boom bust cycle as demand for goods themselves is far more cyclical, look no further than Japan and Germany whose export driven economies have largely languished for the last 20 years in the slow growth/no growth period in the aftermath of the Great Financial Crisis. Let’s put all this into context, according to the World Trade Organization as of 2023 the US had a trade weighted tariff rate of 2.2% lower than nearly all countries around the world. For a country that is such a massive importer one might argue the low levels fostered healthy trade relations with some of our key allies and admittedly some frenemies or altogether poor bedfellows. With these sweeping tariffs, some as high as 49%, this marked a significant shift in policy where the aforementioned tariff rates will approach 30%, having a significant and lasting impact on consumers and businesses alike. Whether you want to describe a tariff as something different than a tax seems to be semantics, the added expense is rarely fully eaten by the producer. In the aftermath of the pandemic and the correspondingly high inflation due to excessive fiscal and monetary policy along with supply side disruptions, its doesn’t require too much detective work to know the average American is exhausted or outraged by higher prices. The tariffs will only add to the price at the register unless we all of a sudden find the private sector extraordinarily benevolent, willing for much if not all of the added costs to result in shrinking margins. By now you have surely figured out why there was such a market kerfuffle, but let’s make sure to fully examine why the result was to shave $3 trillion of market value off of US stocks in one day, which supposedly is the equivalent of 5 years’ worth of tariff receipts. First and foremost, despite opening the year with an economy bumping along with real GDP around 2.50% we have seen a sharp decline in the soft data, where surveys from the confidence board and University of Michigan plumb levels we have not seen going back to the pandemic when fears of a severe respiratory infection and 10% unemployment were front of mind. The hard data has been only a little better as labor has held up thus far, but as we have seen in Retails Sales there are signs that the consumer may be tapped out or growing wearier. With GDP likely to be between negative .5% to positive .50% for Q’1 that it’s like slamming on the brakes while driving in the passing lane. No surprise that there may be a real sense of whiplash. As the odds of a recession have risen, something the President himself acknowledges, it’s safe to assume expectations for earnings growth this year and next seem to be slipping away. With valuations stretched, there has been little margin for error and it’s those stocks, some of the most expensive that have felt the impact that much more acutely. This is why we have heard the “Mag 7” referred to as the “Lag 7” here in early 2025. Now you might be thinking this is likely transitory, a word that is making its rounds again after an ill-feted debut to Wall Street vernacular in 2022. If we are in fact, we are likely to see a shift to a more capital-intensive economy, is it reasonable to justify such high multiples which made more sense in an asset light, intangible heavy ecosystem? It seems hard to justify, from this vantage point. Hopefully, we will avert a recession, but that’s not to say it is an all-clear sign for the stock market. Earnings recessions, like that of 2022, may not lead to large scale job losses and disinflation, but increase the prospects for a bear market. There is a risk here that those fat margins whither because of trade frictions and lead to something more pernicious like a repeat of the stagflation episode of the 1970s and early 1980s where higher inflation sucks the oxygen out of the room leaving little room for real growth. So, what is an investor to do… Well for one thing, maintaining discipline in the form of diversification has helped and likely will continue to, with investors who have roughly half of their portfolio in overseas stocks and fixed income, the positive returns in these two areas have been able to offset some of the decline in US stocks. Incorporating other assets like Treasury Inflation Protected Securities (TIPs), gold or real estate may help mitigate the risk somewhat but as we have seen in the past times of market angst correlations often increase, giving the appearance there is no place to hide. Eventually markets will calm down, as the last of the sellers capitulate, though that process can take weeks or even months to play out. I’ll leave you with some quotes from some of the smartest minds on Wall Street to ponder as we head into the weekend. “Sometimes the share price of a firm tells the CEO of that firm nothing about their company they didn’t already know. Other times, the stock market takes on the role of “active informant.” Stock prices predict investment because they provide business managers with useful information about the future. I think now is probably one of those times. -Neil Dutta, Head of Economics, Renaissance Macro “We all know the math: the stock market has historically grown by 10-11% over the long run but only gone up 60-70% of the time. That means it has corrected 30-40% of the time. Surviving those drawdowns is the price of admission.” -Jurrien Timmer, Director of Global Macro at Fidelity Investments “We are a great nation, the leader of the free world. Yet we squander our political power to appease the textile industry in the Carolinas! We should instead be setting a standard or the world by practicing freedom of competition, of trade, and of enterprise that we preach. -Milton Freidman This presentation is not an offer or a solicitation to buy or sell securities. The information contained in this presentation has been compiled from third-party sources and is believed to be reliable; however, its accuracy is not guaranteed and should not be relied upon in any way whatsoever. This presentation may not be construed as investment, tax or legal advice and does not give investment recommendations. Any opinion included in this report constitutes our judgment as of the date of this report and is subject to change without notice. Additional information, including management fees and expenses, is provided on our Form ADV Part 2 available upon request or at the SEC’s Investment Adviser Public Disclosure website, www.adviserinfo.sec.gov. Past performance is not a guarantee of future results.

Protecting Your Business Legacy: Do You Have a Succession Plan?

By Breakwater Team • March 31, 2025

If you’re a business owner, you’ve undoubtedly spent years building your company and made countless sacrifices. Have you considered how your business will transition to new leadership when you’re ready to step aside and pursue other goals? A succession plan can help preserve the value you’ve worked hard to build. Succession planning is not just about who takes over but how the transition happens to ensure the business’s long-term survival. Whether passing ownership to family, employees, or external buyers, it’s wise to have a strategic plan that minimizes disruption and protects your company’s value. At Breakwater Capital Group , we help business owners develop comprehensive succession plans. With decades of experience, Breakwater is a fee-only fiduciary financial advisory firm serving clients nationwide with wealth management offices in Denver, CO, Paramus, NJ, and Greater Boston, MA. This blog explains why having a succession plan is important, outlines its key components, and shows how Breakwater can assist you in this crucial process.

Protect Your Wealth During Market Volatility

By Breakwater Team • March 31, 2025

Watching the news and seeing sudden drops in stock prices or economic events that threaten your wealth is stressful. Market volatility is becoming more common in today’s fast-paced and interconnected world. However, depending on how you’re invested and what your financial situation is, a volatile market doesn’t automatically spell trouble. At Breakwater Capital Group , we navigate economic uncertainty with personalized financial planning and investment strategies. As a fee-only fiduciary financial advisory firm, we proudly serve clients nationwide, with wealth management offices in Denver, CO, Paramus, NJ, and Greater Boston, MA. In this blog, we’ll explore what market volatility is, how to be mindful of it, and the strategies Breakwater uses to help clients manage it effectively.

Preparing for College Costs: A Guide for Massachusetts Parents

By Breakwater Team • March 24, 2025

Every parent wants to give their child the best opportunities in life, and a quality education is a key part of that. However, with college costs rising rapidly, planning ahead has never been more important. Over the past 20 years, tuition and fees at public four-year institutions have more than doubled, making it essential for families to explore various options and develop a savings strategy. At Breakwater Capital Group , our Greater Boston based wealth management team works with individuals and families nationwide to develop financial plans that incorporate college savings while keeping other financial priorities on track. This guide discusses the rising cost of college, available financial aid, and practical strategies to help Greater Boston parents prepare.