Hunting For Weeds So The Flowers Can Bloom

February 28, 2023

Beware the investment activity that produces applause; the great moves are usually greeted by yawns.

—Warren Buffett

In honor of Berkshire Hathaway’s annual letter being released this past weekend, we thought the best way to introduce this Co-Founders’ Note was to borrow brilliance from the man often known as the world’s greatest investor. In this year’s letter, Warren Buffett highlighted a few of Berkshire’s most impactful investments during the last 58 years. In his customary way, he informed and educated investors and shareholders alike about timeless principles.

For us, we can’t help but read the annual report (or anything else, really) through the lens of trend following. And, in our view, trend following shares many of the timeless virtues espoused by famous investors like Warren and Charlie Munger of Berkshire Hathaway, as well as Howard Marks of Oaktree Capital.

The excerpt that stood out the most to us from the 2023 letter was in Warren’s discussion about the distribution of investment outcomes. He wrote:

“The lesson for investors: The weeds wither away in significance as the flowers bloom. Over time, it takes just a few winners to work wonders. And, yes, it helps to start early and live into your 90s as well.”

In trend following parlance, this quote describes the notion of cutting your losses short and letting your winners ride. In practice, trend followers do not allow the weeds to wither; instead, we go hunting for weeds to remove. But the idea that over the long run a few winners generate the lion’s share of gains is spot on, in our view. A systematic investing process attempts to put you in a position of the highest probability of success by using the information you have in the moment. No predictions, gut feelings, or prognostications.

In this month’s Co-Founders’ Note, we look at the current environment as a good news/bad news scenario and discuss the merits of systematic investing through the framework of risk management and timeframe selection.

But first, here’s a summary of our take on what transpired in the markets in February.

Asset-Level Overview: Market Talking Points for Financial Advisors

Equities & Real Estate

U.S. equities started off February with a bang before a wave of negative news extinguished the short-lived rally. As we end the month, large-cap equities find themselves below the fourth-quarter high and searching for direction. On the bright side, large caps did manage to (unconvincingly) break the downtrend line established at the start of 2022.

Likewise, the end-of-month declines in mid and small caps have only brought them back to retest Q4 highs, with small caps joining mid in uptrends over both timeframes. On the one hand, these conditions are to be expected if a longer-term uptrend is to be established. Realistically though, these movements are perhaps a sign of a sideways pattern that could persist for some time.

The end result is that Blueprint Investment Partners portfolios will experience a small increase in exposure to large caps. Large caps will receive exposure from weaker real estate securities, mid caps will remain underweight overall versus the baseline allocation, and small caps will see an exposure increase too.

Foreign developed equities retraced a bit but remain relatively strong compared to U.S. equities so far this year. Blueprint Investment Partners portfolios moved into an overweight status in February for the first time since late 2021, and they will remain here in March. In fact, foreign developed exposure will increase to its maximum, as it takes on the allocation vacated by emerging markets.

Emerging market equities flirted with triggering a long-term uptrend to join the intermediate-term one in February, then tumbled to end the month, and now have re-entered downtrends across both timeframes. Our portfolios will remain underweight and at their minimum allocation.

Of the equity and equity-like asset classes, real estate securities have done the least to break the pattern in place since the start of 2022. The retracement in the second half of February generated a downtrend over both the intermediate- and long-term timeframes. For now, all portfolios continue to be underweight.

Our Asset Allocations

Fixed Income & Alts

As was seen in multiple equity segments, U.S. and international Treasuries experienced their own decline in February. The decreases are enough to cause these asset classes to have downtrends across both timeframes. As a result, all Blueprint Investment Partners portfolios will move back to their minimum allocations. This exposure will be handed back to ultra-short duration fixed income instruments.

For gold, as might have been expected following the steep increases since the beginning of November, gold fell hard in February. Gold is holding its uptrends but has retested the Q4 highs. For now, our portfolios remain at their baseline allocation for March. If conditions continue to deteriorate, a reduction in exposure would be in order for as early as April.

Our Asset Allocations

Sourcing for this section: Barchart.com, FTSE Developed Markets Vanguard (VEA), 2/1/2023 to 2/27/2023; Barchart.com, S&P 500 SPDR (SPY), 10/1/2022 to 2/27/2023; Barchart.com, Midcap ETF Vanguard (VO), 10/1/2022 to 2/27/2023; Barchart.com, Smallcap ETF Vanguard (VB), 10/1/2022 to 2/27/2023; Barchart.com, Real Estate Vanguard ETF (VNQ), 1/1/2022 to 2/27/2023; and Barchart.com, Gold Trust Ishares (IAU), 10/1/2022 to 2/27/2023

3 Potential Catalysts for Trend Changes: Giving Clients the Context

Real Wage Loss: Wage growth is plateauing or declining from previously high levels. For central banks around the world, it is welcome news because there aren’t signs of a wage-price spiral in which wages push up prices, which in turn push up wages again. This makes inflation less sticky and more likely to decline without a significant increase in unemployment. For workers, it is less beneficial. Workers’ inflation-adjusted purchasing power was lower last year than in 2019, before the pandemic.

Consumer Spending Priorities: Consumers are spending more on food and less on electronics, apparel, and home improvements. Inflation and changing habits have dried up demand for more discretionary goods. As an example, Walmart and Home Depot have enjoyed elevated sales post-COVID as people looked for bargains or fixed up their homes. Now, more of shoppers’ budgets are going to higher-priced groceries and travel.

Millennial Debt: Americans in their 30s have piled up debt at a historic clip since the pandemic. Total debt balances hit more than $3.8 trillion in the fourth quarter, a 27% jump from late 2019, according to the Federal Reserve Bank of New York. It is the steepest increase of any age group and is the fastest pace of debt accumulation over a three-year period since the 2008 Financial Crisis. Unfortunately, this buildup of debt could worsen a generational wealth gap that was already rising for millennials who graduated into the 2008 crisis era.

There’s Good News… And There’s Bad News…

Wisdom is tolerance of cognitive dissonance.

—Robert Thurman

As was covered in the Asset-Level Overview section, for equities we’ve got good news and we’ve got bad news…

The good news is:

U.S. large caps have broken the downward trending pattern reinforced throughout 2022.
Value and dividend segments are moving within single-digit percentages from the highest levels in 20 years.
Mid and small caps are consolidating in a range above their intermediate and long-term averages.
Foreign developed equities have established solid, positive trends across both timeframes.

And the bad news:

While nearly establishing a long-term uptrend, U.S. large caps experienced a very weak close to the month and failed to follow through, leaving the longer-term downtrend in place.
Value and dividend stocks have failed highs and are laggards in 2023 after leading in 2022.
No major equity asset class is seriously threatening new all-time highs as we close out February.
Inflation and employment data continue to support the narrative of more rate increases, not cuts.

It appears that we have a stalemate between the bulls and the bears at the moment. Equities (and bonds for that matter) have yet to seriously retest lows from 2022, but as mentioned above are not threatening new highs either. There seems to be an underlying desire from investors to push the market higher, like they are just looking for a reason to buy. Yet, economic data and subsequent Federal Reserve commentary continues to stand in the way.

Some could argue that directionless markets are the Achilles heel for trend following strategies, but we want to highlight two areas that show why systematic portfolio management via trend following still shines.

#1 – Generally Low Cost of Risk Management

We often talk about how risk management is “baked in the cake” with our systematic investing process. If your rules are designed to allow for participation in ascending markets, while stepping out declining markets, then all you have to do is consistently follow them and you should generally achieve that objective.

The rules that allowed our portfolios to have generally high equity participation in a market like 2021 are the same rules that generated sell signals in 2022 and caused our portfolios to have low or no exposure to the risky assets in 2022.

It’s fairly easy to compare the performance of our portfolios from 2021 and 2022 and see how they held up better than most 80/20 or 60/40 stock/bond portfolios. 2023 is more difficult because as some of these standard, passive portfolios rebound, Blueprint Investment Partners may lag briefly, as the markets seek direction.

Financial advisors should rest assured that despite the extremely short-term underperformance, the same rules and systems that drove 2021 and 2022 are at work today. Our process is designed to constantly look for trends that can capture burgeoning uptrends while continuing to run from downtrends.

#2 – Timeframe Selection

That takes us to timeframe selection.

We are often asked why we don’t choose shorter-term timeframes to trigger more trades. Besides turnover and taxes, another big reason is the inevitable periods of choppy markets like we are experiencing now.

In our research, the effects of sideways movement are exacerbated if shorter trend-following rules are used. So, in our opinion, the positives of a shorter-term system are far outweighed by the negatives.

We have deliberately chosen the timeframes we use to provide what we believe is an optimal balance of minimal turnover, tax awareness, risk management, and opportunity targeting.

Good News/Bad News for Financial Advisors

Paralleling the good news/bad news situation in the markets is one for financial advisors.

The good news is that as we move into March:

Markets are generally positive for the year and have stopped declining, unlike almost every point of 2022.
Underlying sentiment has improved, as a perception creeps in that the Fed is much closer to the end of rate increases and a soft landing is within reach.
While hardly ideal, sideways (albeit positive) markets can make an advisor’s life easier with clients, certainly more so than last year.

The bad news is that:

Clients can be fickle, impatient, and emotional.
An advisor’s value is rarely fully demonstrated during positive periods like pre-COVID and 2021. It is demonstrated right now by how well the advisor does at communicating with their clients, as well as by the tools they have at their disposal to keep clients anchored to their financial plans. In short, the hard work continues.

For those utilizing Blueprint Investment Partners, our hope is that our constant, tireless focus on discipline and service allows you to turn your attention to the critical moments like now that cement relationships with your clients. History has taught us that better times are usually ahead, and we believe your clients are best positioned to benefit from those better days when they remain committed to you and their financial plan.

Sourcing for this section: Barchart.com, Value ETF Vanguard (VTV), to 1/1/2003 to 2/27/2023; Barchart.com, High Dividend Yield Vanguard ETF (VYM), 1/1/2003 to 2/27/2023; Barchart.com, Midcap ETF Vanguard (VO), 1/1/2022 to 2/27/2023; Barchart.com, Smallcap ETF Vanguard (VB), 1/1/2022 to 2/27/2023; Barchart.com, Value ETF Vanguard (VTV), 1/1/2022 to 2/27/2023; Barchart.com, High Dividend Yield Vanguard ETF (VYM), 1/1/2022 to 2/27/2023; Barchart.com, Total Stock Market ETF Vanguard (VTI), 1/1/2021 to 2/27/2023; Barchart.com, FTSE Developed Markets Vanguard (VEA), 1/1/2021 to 2/27/2023; Barchart.com, FTSE EM ETF Vanguard (VWO), 1/1/2021 to 2/27/2023; and Barchart.com, US Aggregate Bond Ishares Core ETF (AGG), 1/1/2022 to 2/27/2023

Best regards,