Operational Risk Management 2023 – Portfolio Go No Go Checklist!

Posted by David Nelson, CFA on January 3, 2023 in Investment Management | Leave a comment

By David Nelson, CFA CMT

All branches of the military use ORM or their own Operational Risk Management system. It’s an imperative before launching any mission and commonly used by pilots in making go no go decisions. We identify the risks even those with low probability and make a quantitative judgement as to the feasibility of the mission and or flight.

Investors need to do their own due diligence and perform a full ORM review of their portfolio and its ability to navigate the many challenges we face at the start of a new year.

S&P 500 2 Years

The consensus view is that the Fed will hike 25 basis points at the next 2 Fed meetings with an outside possibility of a 3rd, letting time do the rest of the work for them. The problem of course with the consensus view is that it is often wrong.

What it does do is give us a starting point knowing full well that the playbook will have to be rewritten several times during the course of the year.

The Terminal Rate

The terminal rate or expected peak fed funds rate sits just south of 5%. Any student of history would have to at least consider 5% as well below what was necessary in previous inflation cycles. The Fed knows this and that is why they are reluctant to give clear guidance on future rate projections. The last thing Fed Chair Jay Powell wants to do is box himself into a corner.

The Fed’s current mandate is to kill momentum in the job market, making Wednesday’s JOLTS and Friday’s non-farm payroll data key to January performance. The number of job openings could come in below 10 million but would still be elevated in comparison to pre-pandemic levels.

JOLTS

The terminal rate or expected peak fed funds rate sits just south of 5%. Any student of history would have to at least consider 5% as well below what was necessary in previous inflation cycles. The Fed knows this and that is why they are reluctant to give clear guidance on future rate projections. The last thing Fed Chair Jay Powell wants to do is box himself into a corner.

The Fed’s current mandate is to kill momentum in the job market, making Wednesday’s JOLTS and Friday’s non-farm payroll data key to January performance. The number of job openings could come in below 10 million but would still be elevated in comparison to pre-pandemic levels.

JOLTS

All of the above are risks but the elephant in the room is still the Federal Reserve and with it the risk free rate.

Most valuation models start with the risk free alternative and with short term treasuries yielding well above 4%, the growth necessary to support high multiple growth stocks is just that much higher.

Growth vs Value 2022

Hence the massive underperformance of long duration equity last year, in particular the popular FAANG trade. The good news is that all of these stocks trade at significantly lower multiples some even approaching that of the broad market.

When rates rise,, appetites change. Investors hunger for yields in all its forms. Dividend, earnings and free cash flow yields are high on the list of what investors crave when the competing risk free rate is elevated.

Price works wonders on improving yields. As price comes in yields move higher. Unfortunately, the important data sets aren’t static and today’s forward look at earnings and cash flow yields could look a lot different 6 months from now. Estimates have steadily moved lower over the last several months as analysts play catchup.

So what does all this mean for today’s investor as we head into 2023. The good news is that you have choices. For more than a decade the Federal Reserve has pushed investors further out on the risk curve.

Growth vs Value – There was no alternative

There is no alternative became the rallying cry of investors willing to pay almost anything for growth. They weren’t wrong. From 2017 – 2021 growth outperformed value by a staggering 119%.

Rising rates and an inflation backdrop not seen in decades forced investors to return to their roots and embrace long since abandoned metrics like earnings and free cash flow yields.

Cash is no longer trash

This year investors can take that concept a step further as it is no longer necessary to be stock centric. With short term treasury yields approaching 5% cash is no longer trash.

Balanced portfolios embracing a variety of asset classes can and will help investors achieve their goals.

60-40 is reborn. With yields the highest in years a balanced portfolio along with other traditional alternatives like gold, commodities and managed futures could provide the stability needed to whether a recession. If you don’t want to venture too far out on the yield curve the short end offers plenty of return reducing duration risk.

Recession?

Not all strategists are on board with the concept of a recession this year. Goldman’s David Kostin just last week published research saying they are looking for a soft landing. If we don’t get a recession it would be the first time in a half century a yield curve this inverted got the prediction wrong. At the very least we have to operate under a high probability threat. Let’s call the current Defense Condition DEFCON 3. We have risks but not enough to trigger a no go decision. 

Where could the above prove wrong?

At the risk of repeating myself earnings could surprise on the upside. Analysts have been cutting estimates for months and as I wrote early last month an earnings report is also a report card on how good or bad the analysts were at getting the number right. With shorts pressing any positive news here could cause an upside surprise. Let’s call that Miracle #1

Any deterioration in employment could spark a significant rally. Investors are desperate for a Fed pivot. Given the Fed is trying to wash away the stain of a disastrous inflation call last year the only shot at an easier Fed is bad news on the labor front.

I’ll say it again. Jay wants you to lose your job and will accept nothing less than meaningful losses in non-farm payrolls and an end to the inflationary upside wage pressures. Anything that would raise the odds of a Fed pivot would likely force a mad scramble back into growth at any price. Miracle #2

Finally, the 100-1 shot. Peace in Ukraine. Yes, I know peace looks as far out of reach as it has since the start of the war but all options need to be considered. Putin’s health is rumored to be failing and the possibility of negotiations while small aren’t zero. The obvious benefits to the continent and the spillover to the rest of the world are obvious. That would be Miracle #3.

Bottom line, a lot of the valuation risk has been taken off the table but with rates still on the rise and the odds of a recession high, risk is still elevated. The mission is a go but heed the immortal words of Sergeant Phil Esterhous from 80’s hit TV show Hill Street Blues, “Let’s be careful out there.”