Dear Clients and Friends,
When markets closed on September 30th, they were ever so slightly in what is called a “pullback,” or down 5% from their recent highs. I thought it might materialize into something worthy of writing about, but then, true to recent form, they quickly recovered. However, since I broached the topic, let me give it some context before moving on. From 1946 through the 3rd quarter of 2021, the market has seen 126 pullbacks. Of those, 29 went on to a correction (-10%), 9 declined into a bear market (-20%) and 3 went off the rails (-40%). The conclusion? Most pullbacks are just noise and only few go on to be something more than that. So, while “buy the dip” is a bit of a complacent investment strategy, it is somewhat rational, in my view, if paired with the mindfulness that there will come a day when the market does not bounce right back.
Stock Market Declines Since 12/31/1945
I talked at some length about inflation in my last newsletter and the topic is showing staying power, in terms of media coverage, even if the consensus view remains that inflation itself is transitory. Granted, it is a topic that grabs one’s attention, so the media coverage is understandable. Nobody likes to pay more and receive the same or less. It is a natural conversation starter, as is the weather and the travails of your local sports team. But it is not all bad news: the Social Security Administration announced that next year’s cost of living adjustment for retirees collecting social security, will be 5.9%. That is the largest increase in 40 years. If inflation proves transitory this will indeed be a nice – and deserved – bump for retirees who have for years been forced to either accept low safe returns or take on additional risk with their retirement savings, because of ultra-low interest rates.
Where there are worries, there are investment opportunities. Clear skies just do not make for the most attractive investment entry points. If the holy grail is to buy low and sell high, finding an attractive entry point is half the battle. So, what else are investors worried about, besides inflation? China. And for good reason.
President Xi is pursuing his Common Prosperity agenda, or perhaps better phrased as his personal vision of what China ought to be. I have attended several webinars of late on whether China is investable for US investors. Some outliers aside, most argue “yes.” However, I am struck by the narrative that is common among China investment experts: “Xi is just addressing the same challenges the rest of the world is facing, in terms of inequality, the environment, education, and the housing market, but in the context of the Chinese form of government.” How one man, perhaps with some input from another 200 men, gets to decide for a population of 1.4 billion people what is fair and equitable is in and of itself the opposite of fair and equitable.
Then there is the issue of Taiwan. Most experts don’t see a Chinese attack as imminent. It would come at a great cost to China, whether the US responds militarily or not. For the US, indeed for most of the world, it is a lose-lose proposition. War across the Taiwan Straits is a nightmarish scenario, and if Taiwan is annexed a la Crimea without a shot fired, it will most certainly result in China’s isolation on the world stage, which would harm trade, supply chains, and global initiatives on addressing climate change. It would also disrupt the world order that, for all its faults, has lifted 1.2 billion people out of extreme poverty since 1990. In effect, China has much to lose and little to gain from changing the Taiwan status quo, and continued engagement on the part of the US and other nations will minimize the chance of any miscalculation and reinforce the notion that our common prosperities are indeed tied.
Is there an investment case for China, given all the negative attention? I believe so. President Xi will continue to confound investors as he remakes the Chinese economy in his image of Common Prosperity. But as is often the case when there is negative sentiment, investors have been indiscriminate in their selling of Chinese equities. This has set the stage for winners to emerge when the dust settles. The key consideration, in my view, is to ask whether the success of the Chinese companies you own shares of, is aligned with Common Prosperity. President Xi does not care about your retirement, but he does care about the buildout of clean energy, a robust digital economy, a society that reduces the stress levels and financial strains of child rearing, a nascent semiconductor industry, and a domestic Electric Vehicle (EV) industry. Those are the areas where your investment dollars will find alignment with China’s objectives and therefore attractive upside, given today’s cloudy skies.
There is an energy crisis unfolding as I pen this newsletter. The press has gotten it mostly right, from what I have read: The global economy is needing massive amounts of additional energy as it restarts, coming out of the pandemic. In places like China, but also in Europe and the UK, coal generation has been phasing out faster than renewables can pick up the slack, especially given the sudden ramp up in demand. At the same time, in certain regions wind and hydro power production has been subpar. It makes for the perfect storm. Demand for coal is soaring and countries are scouring the earth looking for fossil fuel supplies. Oil prices have reached multi-year highs, recently trading at $80 a barrel. It is all very grim.
The transition to renewable energy is irreversible, in my opinion. Therefore, this is more an indictment of the way the transition is being managed, coupled with the mess created by the pandemic, than an indictment of renewable energy itself. There is some risk of course, that renewable energy and its supporters will become the scapegoats and that the political will to address climate change wanes. However, it is hard to imagine that we are going to abandon the switch to EVs, that utilities with 30-year investment horizons will propose new coal plants, that the offshore wind industry and all its job creation will be put on ice, and that innovation in energy storage and grid technologies will be starved of capital.
To the extent that the current crisis delays the energy transformation, that is regrettable, given the urgency we face to address climate change. On that point, the global carbon emissions reduction in 2020 was 100% pandemic related and is forecast to tick back up in 2021 to or above 2019 levels. Starting in 2022, rich countries are expected to continue their ever so gradual decline in carbon emissions, while developing economies will continue to increase their emissions as far as the forecast horizons extend. Much work – and much investment opportunity – remains to be undertaken.
As many of you know, I have offered Socially Responsible/ESG/Impact (take your pick) investing for over a decade. In the beginning it was niche and often dismissed by the traditional investment industry as coming at the expense of investment returns. That has been thoroughly debunked as performance of the SRI/ESG indices have consistently demonstrated.
Fast forward to 2021 and ESG (Environmental, Social, Governance) investing – the preferred term in the traditional investment industry – is all the rage, on par with cryptocurrencies. The latest iteration of the ESG trend is Direct Indexing. You can essentially highlight your values and your investment manager will create a screened portfolio of individual securities that aligns with both your values and a broad stock market index. It really is nothing new under the sun, but just a repackaging of separate accounts customized to your ESG preferences.
The challenge I have with Direct Indexing, is that the accounts I have seen are (over)diversified. They are essentially the index minus some stocks with low ESG scores, optimized back to the index. Diversification dilutes “alpha”, or the return contribution from individual stocks, because you own so many of them that your portfolio has become the market. That is fine, that’s passive investing. It has a better chance of success than investing in most active managers who on average cannot make up for the added expenses they charge. But (over)diversification also dilutes ESG impact.
For example, say you were investing in the S&P 500 and had a very low ESG bar and only 1 stock did not make the cut. You would buy the other 499 and your ESG strategy with be uber-diversified but not very impactful. Alternatively, you could have a very high bar and only one 1 stock cleared it. You would have a very concentrated portfolio with a very high ESG score. Those are the bookends, but the idea is that the more stocks you hold, the more you have diluted your ESG score. A US stock portfolio that is serious about ESG probably shouldn’t hold 150+ stocks. In fact, for diversification you really don’t need that many holdings. Most of the diversification happens with the first 20-30 stocks. Once you cross over 100, you are giving your manager more places to put the money, which can be advantageous to them, but it doesn’t do much for you in terms of diversification and dilutes the ESG intention of your portfolio.Writing has been beneficial to me and the work I do beyond its primary objective of communicating to my clients and readers. It helps me organize my thoughts and distil insights that just needed some note taking to come to fruition. Though I enjoy writing, I am not a prolific writer, nor does the world need me to be. Enter podcasting. I am two episodes into it and must say it is kind of fun. It serves the same purpose as my writing, but without the need for spell/grammar check and proper sentence structure. If you got this far into my newsletter, you probably like reading or you are holding out hope that something worthy lies ahead. Be that as it may, we would love for you to check us out on Spotify and subscribe if so inclined: https://spoti.fi/3m4Nssg
I couldn’t do it alone. Standard language in every acceptance speech, but for good reason: few can really do it alone. So, I wanted to leave you with an update of our team to whom I am grateful and by whom I am empowered to serve my clients. I will kick it off:
Jan – yours truly. The most eventful part of my 2022 is still a couple weeks out: we are expecting the arrival of our 2nd child in November. Nicholas started preschool in September and is ready to take on big brother responsibilities. I have been biking more, running less, and looking forward to traveling beyond my 500-mile car trip radius next year (yes, with the family).
Terri – Operations & Client Service Manager: “I’ve been enjoying a gorgeous Colorado fall with lots of hiking and time spent outside before the chill of winter arrives. Our community has so many volunteer opportunities, and I have been enjoying my time volunteering for Project Angel Heart, a Colorado non-profit organization that caters meals to individuals battling life threatening illnesses in the greater Denver area. I’ve also enjoyed time volunteering at the Denver Botanic Garden – the beauty of the gardens feeds my soul. And I got to enjoy several extended travel weekends to go see our adult sons and time with friends.”
Meghan – Financial Planning & Tax Consultant: “The move back from Germany to the US is going well, and my spouse and I will be settling down in Colorado Springs as soon as we finish house hunting over the next few weeks. Other than that, it has been all work related of late. My book and the Conscious Impact Financial Planning Academy (financial planning for DIY’ers) will be released to the public in the next month or so.”
Tom – Research Analyst: “I recently helped my local community of Marbletown, New York, get $75,000 worth of NY State grants for environmental leadership which we’re using to buy a Plug-in-hybrid vehicle (PHEV) for our building department and outfit the town maintenance department with an electric riding lawnmower and other yard equipment. I had run at least one half-marathon (the distance, only a few were formal races) each month for 3 years until I broke the streak in June 2021. Now I’m paying attention, and plan to beat that streak sometime in August 2024.
Wishing you a colorful fall and soon a holiday season that is all wish for and nothing you dread.
Jan Schalkwijk, CFA JPS Global Investments