“Uncertainty! fell demon of our fears!
The human soul that can support despair,
supports not thee.”
-David Mallet
Uncertainty is an ever-present element of investing that no one enjoys. While it waxes and wanes over time, it’s certain that uncertainty is thick about us now.
Large US stocks started the new year advancing, peaked in February, quickly sank 10% into a “correction” by mid-March, and the S&P 500 Index ended the first quarter down nearly 9% from the February all-time high. This is not an uncommon occurrence: nearly one in two years includes a 10% market correction (or two). Importantly, most don’t go on to become bear markets - declines of 20% or more.
Political division, seemingly our national pastime now, fills the airwaves, blogosphere, and chats. Yet as tempting as it is to color investment decisions with our respective political poisons, it’s almost always best to filter that stuff out.
“Stocks Fall on New Auto Tariffs” (WSJ, 3/28) was a typical recent headline. Nearly everything you read or hear points to concerns about tariffs as the reason for recent market weakness. Economists, for all the usual quips about their equivocation, are remarkably united in their view that free trade is good and tariffs are bad. We concur. Yet despite conventional wisdom that tariff talk is the cause of current market jitters, we are not convinced it is the principal driver of this correction. Neither is simmering inflation nor even geopolitics. Odds of recession have meaningfully risen, and that is almost certainly a factor, perhaps more potent than the others. Exceptionally high market valuations are a much less-cited cause of near-term market declines, but we think they are likely the primary culprit for this correction.
Market valuations have been stretched for some time, as we’ve noted. The overall stock market remains both expensive and concentrated, and the correction has done little to improve either of these conditions. Fortunately, not everything is as expensive as the largest US tech companies, and among the less expensive opportunities are non-US stocks. In the first quarter, while the S&P 500 Index total return was -4.6% (and that of the tech-heavy NASDAQ index was -10.4%%), the MSCI All Country ex-US Index return was positive 5.5%, delivering substantial benefit from international stock diversification. Moreover, except for small stocks, essentially all forms of diversification were beneficial to investors in the first quarter, including bonds.
As to the economy, several recent reports indicate the economy heading into this year was weaker than most had previously imagined, and little has been done lately either by the Fed or by Congress to change that. One underappreciated development found in a Wall Street Journal opinion piece in February is that in 2024, the Federal Housing Administration (FHA), which insures mortgages for low and middle-income borrowers, had more loans become seriously delinquent than it insured new loans. Furthermore, the missed payments were simply added to those delinquent mortgage balances, while the FHA paid servicers not to foreclose. More newly issued FHA loans last year went delinquent within 12 months of issue than occurred at the peak of the 2008 subprime mortgage debacle. If these 8.5 million FHA delinquencies become foreclosures, the odds of both a recession and a bear market could increase. Fortunately, for now, at least, this appears to be an FHA problem rather than an issue for the mortgage market generally.
Longer term, unsustainable levels of government spending and debt remain the elephant in the room, and, if unaddressed, will continue to raise the odds of serious eventual market adjustments, as we have noted before. Every administration seems to target “waste, fraud, and abuse.” Few have made any progress. We hear and appreciate concerns voiced by many these days about what the current government is doing to cut spending. “Move fast and break things” plays better in Silicon Valley than in DC. But if current hasty efforts to curb federal spending are unsuccessful – and there are many reasons to expect they may fall short of stated goals – the result may be no more than a slowing in the rate of government growth. The two principal reasons for that are Social Security and Medicaid, and anything short of addressing their financial problems would leave the best of other efforts short of bringing us to fiscal responsibility. In other words, all these endeavors may only delay the day of reckoning.
Given these substantial near- and long-term risks, it seems foolish not to focus on diversification and risk control in portfolio management. Recent years (especially 2021, 2023, and 2024) have served to “teach” too many the wrong investment lessons: chase after momentum and ignore valuation. This year so far, with risk rearing its head, our adherence to prudence is paying off well. We will continue to allocate portfolios with care and caution. You know that storms in investing arise from time to time, but you may take comfort in knowing your portfolio is built to weather this one.