Meet a Strategist is a feature where Evan Harp talks to different strategists about how their firms are responding to the current moment. This week, he sat down with managing partner and chief investment strategist Fritz Folts.
Evan Harp: What’s keeping your clients up at night?
Fritz Folts: That’s a great question. I would say, in general, everything that has transpired this past year has reintroduced investors to investment risk. Since the financial crisis, we went through this very long period where it seemed like the S&P 500 only went up. We had very easy monetary policy, low inflation, and low interest rates. But now, in 2022, all of that has changed.
Investors are now confronted with a rapid rise in inflation, rising interest rates, and tightening monetary policy — and that’s a challenging environment. I think what really took people by surprise this year is that, based on the fact that we had this spike in inflation and rising interest rates, their bond portfolios didn’t help them. That’s traditionally what happens: You rely on your bond portfolio to help you during periods when the equity markets decline. But that wasn’t the case this year. In fact, I think this year was the worst year of investment performance for a traditional 60/40 portfolio in decades. So, I think it’s a compilation of things that have made 2022 challenging and continue to have investors on edge. There is just a heightened level of uncertainty.
Harp: Do you have any recent changes in your allocations?
Folts: Based on our model research, we have been positioned defensively throughout this year. Even after the correction in the S&P 500 thus far in 2022, it is still significantly overvalued by our measure.
However, our research also indicates that other equity markets are significantly undervalued at this point, including the ex-U.S. equity markets. The Fed is rapidly and aggressively tightening monetary policy; when they do that, you see the dollar’s value rise. And, as we know, emerging market countries and equities tend to struggle under strong dollar regimes. However, now that the Fed is expected to at least slow the pace of tightening, we have seen a pause in the rally in the dollar. We think this could continue, and we believe this could be supportive of emerging market countries and emerging market equities.
So, we’ve recently added an initial position in an ETF that holds a basket of emerging market (EM) equities, which could benefit should the dollar continue to weaken from here. Our model research considers EM equities to be undervalued and the U.S. equity market to be still significantly overvalued.
Harp: What do you think of the markets right now?
Folts: Well, I would say that we remain cautious. I would also say that until proven otherwise, we would have to say that we believe that we remain in a bear market. One of the things we’ve seen this year is the market rally, right up to its 200-day moving average, and sometimes break through for a couple of days. But it hasn’t been able to break through for an extended period, which is typical in a bear market.
We describe bear markets in three phases; you have this period of profit-taking as price momentum and trends break down. That’s what we’ve had thus far in 2022. But then there’s a second phase to a bear market, which occurs when additional selling due to weakening prospects for corporate earnings starts to emerge. We haven’t seen that yet. But as we get into early 2023, we’ll have companies report their fourth-quarter earnings and guidance for 2023. That could be where we might see those earnings come out softer and guidance come out a bit lower, which might be disappointing. So that’s the type of thing that could initiate the second stage, or phase, if you will, of a bear market. We haven’t seen that second phase yet. Then the third phase is when the bear market picks up pace and gains momentum when you have distressed selling and investors having to sell for liquidity reasons, such as margin calls.
If we are in a bear market, we’ve only had one of the three phases that we described. So we feel like it could continue into 2023. However, it is also true that an overvalued market can continue higher and become even more overvalued. So that’s certainly greater than 0% probability, and you have to be prepared for that possibility as well.
Harp: Are there any types of ETFs you want to highlight?
Folts: I like this question. Several members of the 3EDGE core team have worked together for the past two decades at 3EDGE and other firms and have been pioneers in creating globally diversified portfolios of index ETFs. The growth of the ETF market helped us dramatically because it gives us more options to gain the exposures we’re looking for.
Most of the time, we’re looking for straightforward index exposure to an asset class or geography that we are interested in. We seek exposure through ETFs that are liquid, transparent, low cost, and where there is minimal tracking error.
We understand that there are all kinds of different ETFs: active, passive, leveraged, inverse. For the way that we invest, we’re really looking for more plain vanilla ETFs. Having said that, we are constantly investigating other types of ETF vehicles that we may utilize in the future.
Harp: What’s one thing that sets your firm apart?
Folts: I would say, first and foremost, we believe that we have a unique philosophy and approach. We view the global capital markets as a complex system of interrelated variables. That’s different from most approaches on Wall Street. Often, we refer to our approach as a risk-managed approach to tactical investing. We seek to provide strategies with a lower beta to traditional stock and bond markets but to do so without sacrificing return potential.
I think the other thing that sets us apart is our people. Many say that, but our core investment research team, and most of our investment committee, have worked together for the better part of two decades. So, we have a great deal of experience, we’ve been through both up and down markets, and I think that’s another aspect of 3EDGE that sets us apart.
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