The harmful effects of inflation finally took their “pound of flesh” from the markets. Although the war in Ukraine impacted the markets, the effects seem to be fading — as is so often the case with geopolitical events. The markets rallied in the last half of March as the Russian offensive stalled and quick victory eluded Putin. Although what happens next is uncertain, we all hope it does not escalate.

For the markets and economy, the main threat is inflation and the responses required to curb it. The Fed is desperately trying to catch up after dismissing inflation last year. At first, inflation was blamed on the pandemic. Then it was described as beneficial. Then it was blamed on supply chains. Next it was described as transitory. Then it was blamed on Russia. Honestly? We have no one to blame but ourselves. The economy must now digest the money we’ve thrown at it.

On a serious note, I genuinely urge everyone to prepare for a recession — whether it happens or not. That does not mean selling assets and running for the hills. In fact, the opposite is true. It is crucial to own and hold productive assets during economic slowdowns.

So what does preparation look like?

  • Examine your cash flow. Look for areas to reduce spending, especially discretionary expenses. Fund any shortfalls strategically, using the most advantageous source of cash. Prioritize your obligations.
  • Review or increase your emergency fund. Make sure you have at least six months of cash reserve.
  • Look at your exposure to risk and adjust accordingly. If you are overexposed to risk in personal and business areas, consider scaling back. Remember, during times of economic stress, capital becomes expensive and scarce.
  • Reduce debt. Refinance and pay off debts while rates are low. Do this now.
  • Planning to retire in the near future? Review your options to make sure you are still comfortable with retiring. Reduce spending in non-essential categories in the first few years of retirement.

Markets and the Economy

Outside of commodities, last quarter was the worst quarter across assets classes since 1981. Experiencing negative returns were large-cap, small-caps, emerging markets, developed international, real estate, corporate bonds, and Treasuries. Good old long-term US Treasuries fell more than 10%, depriving investors of what is normally a hedge or safe haven in times of trouble. The markets hit lows during the initial stages of the Russian invasion, but rallied by the end of March. Many of the extremely oversold tech names that got hammered led the rally in a classic oversold bounce.

Within equity styles and market cap, large-cap stocks beat small-caps and value beat growth until about halfway through March. Energy and utilities were the only positive sectors (but only represent just over 5% of the S&P 500). Communication services, consumer discretionary, and technology were the worst performing sectors.

The bond market experienced its worst quarter since 1980 as inflation soared. Short-term and floating rate debt did the best, but the longer the maturity the worse the performance. In March, the Fed finally started to increase interest rates with an initial 0.25% increase — and plans to keep raising them. If they hold their course, short-term rates could be 2.0% by the end of the year. The yield curve has now flattened and continues to flirt with inversion, signaling economic slowdown ahead. We are keeping our fixed income maturity exposure to the short side, because if the Fed fails to adequately tame inflation, we have only witnessed the beginning of the bloodbath in bonds.

Model Portfolio Performance and Positioning

The Managed Income model was down 3.3% for the quarter but outperformed the Bloomberg Barclays U.S. Aggregate Bond Index, which was down nearly 6.0%. Long-term Treasury bonds lost around 10.5% for the quarter. To minimize negative effects of inflation and rising interest rates, we had previously reduced our exposure to longer-term bonds. These bonds contain too much risk for the meager return offered by their low yields. Our bond exposure is overweighted in short-term alternatives, while the Fed is engaged in a cycle of raising interest rates. Our fixed income exposure remains flexible, using a laddered approach to minimize the negative price impact of rising interest rates. The primary objective of Managed Income is to preserve capital on an inflation-adjusted basis, with a secondary objective of income. The portfolio is conservative by design and seeks to minimize risks inherent in assets classes such as volatility, credit, interest rates and inflation. The returns will be constrained as the Fed raises interest rates, but if they are able to keep on the path, it will increase future returns.

Within our equity and growth strategies, Fundamental 20 was the best performer for the quarter being down only 3.2%.

This strategy focuses on highly profitable companies that have excellent value compared to their cash flows and/or net income. This strategy has a value focus that has benefitted from the current economic environment. Four new names were added to the strategy in March: Best Buy (Specialty Retail), Evercore (Capital Markets), Interpublic Group (Advertising Agency), and Olin Corporation (Specialty Chemicals).

The Fast Movers strategy has had a difficult year in conjunction with technology and growth stocks. It is down just over 13% year to date after being down around 24% in January. It is an aggressive strategy that seeks high growth but has regular large drawdowns. The strategy continues to rotate out of some of the high-flying names that soared during the pandemic. We have significantly reduced our Moderna position and added to our Tesla position at the beginning of March. Our Dollar Tree position has steadily increased as many of the tech names struggle. We added positions in Broadcom (Semiconductors) and Vertex Pharmaceuticals (Biotechnology) in April.

The Liquidity Factor Strategy was down 10.78% for the quarter.

This strategy uses a proprietary method to take advantage of pricing anomalies in stocks that are less liquid and relatively ignored by the market. The strategy is comprised of 10 holdings that see little turnover. This strategy can struggle during periods of high volatility. The primary exposures remain in the Consumer Cyclical and Healthcare sectors. The Relative Strength ETF Strategy was down around 3.3% for the quarter and is currently signaling caution. It is now defensively allocated to Consumer Staples and Treasury Bills.

The Top Flight Model Portfolio was down 7.2% for the year. By way of comparison, this was better than the NASDAQ (-9.1%) and slightly better than Small Caps (-7.5%) but lagged the S&P 500 (-5.1%) and the Dow Jones Industrials (-4.6%). Top Flight continues to be comprised of 25% Fast Movers, 40% Fundamental 20, 20% Liquidity Factor, and 15% ETF RS. Among our overall equity holdings, the top five performers for the first quarter were US Steel, Kohls, Palo Alto Networks, Dollar Tree, and Omnicom. The worst performers were Foot Locker, Moderna, Advanced Micro Devices, Intuit, and NVR Inc.

*All Data in local currency and price only unless specified as total return (TR). Sources: MSCI, Barclays, Commodity Systems, Inc (CSI, YCharts), IDC, Ned Davis Research, Inc., S&P Dow Jones Indices. See Disclosures on page X for information on performance, risks, and benchmark

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