The Wisdom in Knowing You Know Nothing

March 31, 2022

The only true wisdom is in knowing you know nothing.

—Socrates

It is a common tendency for people to extrapolate recent events into the future as a permanent and continuing condition. This cognitive error shows up consistently in our daily lives and especially in the minds of investors. There’s nothing like the markets to push our buttons. So, what do our minds do with the fact pattern of the first quarter? U.S. equities experienced an all-time high, a -14% peak-to-trough drawdown, and a rip-your-face-off-type rally from the lows of nearly 12%. Now that’s a quarter!

Where do we go from here? At Blueprint Investment Partners, we rely on a systematic investing process to guide our decision making. No emotions, predictions, or guessing are part of that process. To execute that process flawlessly, it’s our view that we must accept the reality that we know that we don’t know. Doing so requires humility. In fact, if we don’t humble ourselves, the markets will most assuredly do it for us.

To us, executing our process in the “hot seat” requires a completely objective mindset. The irony is that, for us humans, that is nearly impossible. This is precisely the reason we rely on a set of rules to make our asset allocation decisions. Where do stocks go from here? No one knows or will they ever. For us, it’s about probability and attempting to put the odds of success in our favor over the long run.

In this month’s Co-Founders’ Note we discuss the need to be adaptable, especially when in the hot seat. Maintaining discipline in the face of uncertainty is in the job description of a professional money manager. How do we do it? By combining a good process with the necessary psychological ingredients to perform consistently over time.

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

Asset-Level Overview: Market Talking Points for Financial Advisors

Equities & Real Estate

After twice challenging February lows in early March, U.S. equity markets staged a significant rally and surpassed February highs to re-establish uptrends across all timeframes that Blueprint measures. All of the major domestic cap levels and factors benefited, but many of those most negatively impacted prior to March – such as growth and tech stocks – recovered the most. Though more modest in their short-term returns, value and high-dividend stocks have increased enough to move into the black for 2022.

International equities were boosted by evidence of progress in ceasefire talks between Ukraine and Russia, but pressure on Chinese stocks kept emerging markets in the red for the month thus far. Both emerging and developed indexes remain in downtrends across all timeframes and are weaker than their U.S. counterparts. As a result, Blueprint continues to be underweight in all portfolios, as it has for many months now.

Our Asset Allocations

Fixed Income & Alts

It was another month, another poor performance from fixed income assets. The benchmark iShares Core US Aggregate Bond Index fell approximately 3%, pushing its year-to-date loss to around 6%. Global bonds fared even worse, declining more than 4% and dropping 2022 declines to approximately 8%. Even inflation-protected bonds continued their struggles after briefly rallying to begin the month. The result is that Blueprint will continue to take a win-more-by-losing-less approach, as it has for many months, focusing fixed income exposure to ultra-short-term bonds, which have held up quite nicely.

While essentially flat in March, gold continued to be a good diversifier for the month. It maintained uptrends across all timeframes and will remain at its maximum allocation in all Blueprint portfolios. The goal is for it to continue to act as a hedge against tail risk, both from an inflation and geopolitical standpoint.

Our Asset Allocations

3 Potential Catalysts for Trend Changes: Giving Clients the Context

Talk to me Goose: The bond market is currently pricing in an elevated step up in rate hikes, as the Fed continues to message a stronger reaction after recent data suggested inflation is accelerating. Implied Fed Funds rates for May, July, and November are calling for a 50bps hike for each of those meetings, with hikes also at the June, September, and January 2023 meetings. That would be at least eight more rate hikes this year and a Fed funds rate of 2.25% by the end of the January meeting.

Watch the Birdie! March’s Consumer Price Index (CPI) print, to be released April 12, could be the highest print for this cycle of headline inflation, with consensus estimates at 8.5%. Core inflation should also peak in tandem, with consensus estimates around 6.5%. This is primarily due to tough year-to-year comparisons. Monthly prints are still expected to run at a 4-5% rate, or higher, for at least the balance of the year, and current estimates are that we will end the year with core CPI around 4.5%-5%.

Because I was Inverted: The yield curve is the graphical representation of interest rates between three months and 30 years, which usually tends to slope upwards to reflect the greater risk inherent with longer-term bonds. The 30-year rate, one-year forward, has hit 68 basis points below the forward two-year rate; this is a level not seen in more than 30 years. Additionally, the one-year forward yield curve is fully inverted, where each longer rate is lower than the prior shorter rate. Currently, the bond market is estimating a recession with a summer 2023 due date and the first Federal funds rate cut in Q4’23.

Adaptability In The Hot Seat

During an environment that appears risky – like a pandemic, rapid inflation, or the threat of war when global equity prices are rapidly declining – it is easy to assume that we should be more defensive. However, just as quickly as things went from rosy a few months ago to correction territory, the opposite can occur and markets can rapidly make new highs. If that occurs, then the inverse emotion rapidly sets in, and fear transforms to FOMO.

—Us (yes, we did just quote ourselves!), in last month’s edition of this Note

By following price action in general, and trends specifically, circumstances sometimes play out in a way that makes a practitioner look prescient even while they are rejecting the notion of prediction, as the excerpt from last month’s Note illustrates. Of course, we don’t follow trends for looks at all. The goal is to remain adaptable to an ever-changing set of circumstances. Few months and quarters sum this up better than what we are experiencing as we put a bow on the first 90 days of 2022.

The first quarter experienced a new all-time high in U.S. stocks, followed by a waterfall-like decline and subsequent recovery. That feels unique, but was it? Well, if you go back almost 100 years in the S&P 500, the first quarter of 2022 ranks just outside the 10 ten worst first quarters for the number of days with negative returns. This is particularly remarkable when you consider this is the case AFTER one of the strongest 10-day periods in the index’s history. In fact, as recently as March 11, the S&P 500 was on pace for the most down days in the first quarter in the last 100 years! The subsequent rally was so persistent, it moved Q1’22 out of the top 10.

As we reviewed the state of price trends over the weekend of March 12-13, it become evident that the most tactical variations of our strategies would be headed for their maximum level of defensiveness at the asset class level if current conditions held. We were beginning to gear up and prepare to put this into motion at month-end. U.S. equity prices had followed international stocks into downtrends across the timeframes we focus on. Real estate was joining in the downtrend party as well. Bonds were once again failing to provide any diversification, rather they were arguably the worst performers.

To be clear, as of two weeks ago we were preparing for a scenario of minimum equities and maximum allocations to ULTRA-short-term fixed income instruments. That’s about as defensive as we can be. Then a funny thing happened that is typical if you follow markets closely. Without warning things began to reverse course.

Fast forward to today and not only have the imminent long-term downtrends disappeared for U.S. stocks as an asset class, but intermediate-term trends have strengthened and have entered uptrends as well. The result is that we are INCREASING exposure to U.S. stocks and real estate for April compared to March, as well as reducing allocations from ultra-short-term fixed income.

Now let us repeat (in bold) another sentence we stated last month: The solution, in our view, is that we must constantly remind ourselves that we do not know what happens next.

At the low March 8, the S&P 500 was down 12.4% after challenging the lows set February 24. Since then, it has increased more than 10% to surpass its highest level since mid-January. Though work remains to establish new highs, one must admit this is an impressive recovery.

When we talk to advisors about our approach, some typical feedback is how intuitive and relatable it is to them and their clients. Some version of “this sells itself” is common. The next most common comment usually follows in the form of a question: “Why doesn’t everyone do this?”

Our answer is, “because it’s hard.” It takes conviction in our process to add back equity exposure with the fresh memory of declines and with the prospect of a reversal back to lows. Should markets recover to all-time highs in the near-term, it will have looked easy in hindsight, having bypassed a large portion of the volatility in Q1 and reengaging equity exposure at nearly the same point we exited. However, two weeks ago, we were fielding serious questions about what would happen to markets in the event of nuclear war, and now we are getting uptrends in equity markets.

It’s all about adaptability.

People often mistakenly assume that the reason some investors outperform others is related to the investment process itself – that there’s only a few BEST processes out there and you have to try to find the diamond in the rough. We think it is less the about the process and more about the humility to know that you don’t know, having conviction, and staying disciplined about following the process consistently (even when it’s hard or even when outsiders might look at you with a raised eyebrow). When you combine a good process with these psychological ingredients, long-term results tend to go from good to great.