Today’s higher than expected August CPI report, rattled the market dramatically, causing the Nasdaq to drop by 5.2%, the S&P 500 by 4.3%, and the Dow to drop by 4%.  This was the biggest down day since June of 2020 and the 8th daily decline of greater than 3% on the year.  The recent decline in commodity prices and signs that the housing market is starting to buckle, led market expectations to point towards lower inflation, meaning less rate hikes.  Unfortunately, the government’s method of calculating inflation lags the impact of housing by nearly a year, so we are still filtering through the gains of last year, while services such as Healthcare also showed big gains.  Food inflation is the highest in over 40 years!  When the market tanks like it did today, no sectors are spared, but as we’ve been writing about all year, rate hikes don’t hurt every company or sector equally.

Financial stocks such as banks and insurance companies benefit from higher net interest and investment income.  Higher volatility is good for the trading businesses at investment banks, so I’d expect earnings to be pretty decent.  Wells Fargo this week announced that they are very confident in their call for a 20% increase in net interest income, which is just an astronomical figure on this massive revenue generator, offsetting other areas of potential weakness such as deal activity.  Other banks echoed similar confidence, along with strong guidance on trading revenues, which is very important for stocks such as Citigroup, JPM, and Bank of America.

Most companies aren’t reporting obvious signs of a recession, outside of some housing related sectors, which are most heavily impacted by higher rates.  I think a recession is inevitable sooner than later if we aren’t in one already, but I don’t think it will be anything like 2008, but instead will be the more mild variety like many have been post-WW2.  There are still a lot of signs underneath the hood that inflation leading indicators are starting to weaken, which will filter through the CPI data with a lag.  By the time that data indicators conclusively show us in a recession, or that inflation has definitely peaked, the bear market will likely already have been over, which is why you don’t want to overreact to the negativity.

Our strategy all year has been marked by conservatism.  We’ve used covered calls and sold puts with very large cushions on stocks that we wanted to own if the market crashed, and these strategies have provided significant protection, far better than stocks or bonds have offered, and the benefits should improve the closer we get to late January when most options expire.  Several of our large positions trade at valuations that have previously marked peak bearishness in prior market swoons such as 2020, Brexit, 2018, 2011, etc.  This is despite being highly profitable with stable to growing dividends, often in excess of 4%.

Volatility is very high and we are only 4 months away from when we have a bulk of our options expire, so time decay and volatility going to zero, should provide a nice tailwind.  It’s a very challenging market and macroeconomic backdrop, but that almost always creates many of the best investment opportunities.  The surefire way to destroy your returns in panicking or trying to time the market.

JP Morgan found that over the 20-year period (2002-2021) the S&P 500 had an annualized return of 9.5%, while the average investor had an annualized return of just 3.6%.   The way to get good performance is not acting on emotion or chasing short-term performance.  I’m preaching to the choir to many of you that have proven to be long-term investors, but it’s important to reiterate those keys to investment success.  In my 20 years in the industry, I’ve never seen an investor panic sell out of everything and then be glad they did so two or three years later.  We are in that lull period where there is about 1 month before earnings start coming out in mass for the 3rd quarter, but I expect earnings to be pretty solid for our portfolio of companies, which should help their stocks meaningfully.  Assured Guaranty and MBI should benefit from a hopeful approval of the Puerto Rico Highway Transit Authority credit in the next few weeks, which should be a nice catalyst, as that was their most worrisome credit and it will lock-in a relatively strong recovery, far in excess of what most pundits predicted.  Stocks such as Citigroup, Alphabet, Meta, Ally, and LendingClub trade at some of the lowest valuations in their history, despite being robustly profitable.