Action Breeds Consequence in the Sky

You hardly ever hear about the ozone layer anymore. If you were around in the mid-80s and ‘90s, concern about the degradation of the ozone layer was everywhere. Schools, the media, and even popular movies[1] were bringing attention to the risks of the ozone layer disappearing. And now? Nothing. This shift has caused the skeptical among us to conclude that the panic over the ozone layer was just another hyped-up fad, part of an agenda of overreactive environmentalists to influence government policy. Yet, that’s the opposite of what happened.

Ozone is a naturally occurring gas that settles high up in the Earth’s atmosphere. One helpful property of this gas is that it absorbs a portion of the sun’s UVB radiation that is associated with a number of harmful effects ranging from skin cancer to macular degeneration. In effect, this layer of ozone in the atmosphere acts as a kind of global sunscreen with a very high SPF rating.

In 1985, scientists discovered that a continent-sized “hole” appeared in this protective ozone layer over Antarctica every Spring[2]. While this was the most apparent symptom, the ozone layer was also thinning all over the world. Shortly thereafter, chemicals called chlorofluorocarbons, or CFCs, which were a byproduct of many consumer and industrial applications at the time, were determined to be the primary cause of ozone depletion. Fearing that the entire planetary ozone layer was under threat if nothing was done, scientists sounded the alarm, their warnings “went viral” (in today’s vernacular), and a worldwide push to remove CFC-producing chemicals and other ozone-depleting substances from products became the official policy of 43 industrialized nations with the signing of the Montreal Protocol in 1987.

As a result, global emissions of ozone-depleting substances have declined by more than 99% since their 1989 peak. Since that time, ozone levels in the atmosphere have stabilized and started recovering. Scientists expect the ozone layer to potentially achieve pre-1980 levels of concentration by the middle of this century. With the cause of the problem removed and ozone levels recovering, the issue fell out of public interest. Thus, it is rarely discussed today.

Action Breeds Consequence on Earth 

In our last quarterly communication, which was supposed to cover the first quarter of the year, we ended up spending most of our time discussing events that occurred during the second quarter, namely the Trump administration’s “Liberation Day” tariff announcement on April 2nd and the ensuing stock market[3] sell-off. As it turned out, the 12% decline in the four days following the tariff announcement was the worst of it and stocks subsequently recovered to pre-Liberation Day levels by May 2nd. They then went on to surpass February’s market peak a couple days before the close of the quarter.

With stocks once again sitting at all-time highs, it’s easy to dismiss the risks that emerged during the quarter and bask in the blissful belief that stocks are predestined to continuously rise regardless of government policies. And who could blame investors for thinking that way? A clear pattern has been established over the past decade of somewhat frequent market drawdowns that get resolved relatively quickly by policy actions. Five times in the last ten years, stocks have experienced drawdowns ranging between 13% and 34%, fiscal and/or monetary policy came to the rescue, and stocks rapidly recovered to new highs. In fact, only one of these recoveries took more than five months for stocks to achieve a new high.

Figure 1: Stock Market Drawdowns in the Past Decade

Importantly, like the ozone layer’s gradual recovery, the reason stocks recovered so quickly this quarter is because the cause of the decline was removed. Or, technically, it was delayed on April 9th when President Trump pushed back the implementation of his most punitive tariffs for 90 days and instead settled on a relatively mild 10% global tariff with a higher 30% rate on imports from China. This was in stark contrast to the originally proposed tariffs ranging as high as 50% on imports from key U.S. trading partners and a debilitating 145% levy on Chinese imports. Given the speed of the policy reversal in the face of recoiling stock and bond markets, investors have largely interpreted this delay as a resolution to the threat tariffs pose to global trade, although the President himself has given little reassurance that that is the case.

The takeaway here is not that stock market declines will inevitably resolve rapidly in the future. Instead, the lesson is that policymakers are extremely sensitive to gyrations in the stock and bond markets and will generally use the tools available to them to maintain orderly markets and foster a healthy investing environment. However, this assumes policymakers have the necessary tools available to them, which may not always be as simple as reversing one’s own policy.

While the free-market system in the United States is an incredibly powerful force for creating value that is then expressed through stock prices that generally rise over time, there is no divine right of the stock market to steadily increase in value or experience only small interruptions of this compounding along the way. Neither of Moses’ tablets were inscribed with the words “The stock market shalt not go down for any prolonged period.” Taking it for granted through the imposition of self-inflicted policy errors or through overly optimistic financial planning assumptions is done so at our own peril. Markets ended the quarter operating under the assumption that the tariff threat has been resolved, but the cautious tone of business leaders, monetary policymakers at the Federal Reserve, and consumers indicates that assumption is based, at least in part, on a healthy dose of hope rather than solid evidence that the cause of the April sell-off has been eliminated for good.

Is It Safe to Go to the Beach or Not?

While many of our peers were firing off missives in the heat of the sell-off energetically listing all sorts of ways to reorder your investments to avoid further declines in risk assets, our advice – consisting of reminders that we prepared for periods of market stress ahead of time, that we still had confidence in our clients’ investments, and to stay the course – sounded positively bland. We admit we are not the life of the party, nor did we have any way of knowing the sell-off would reverse so quickly, but our cautiously optimistic approach, as boring as it may seem, once again proved successful in navigating a tumultuous period in financial markets.

After an exciting three months, we find ourselves essentially back where we started the year with financial markets indicating an expectation for economic acceleration and displaying a fervor for all things related to AI. Stocks are at all-time highs and trading at a relatively expensive 22x expected earnings compared to their 30-year average of 17x. Additionally, many Technology companies benefiting from enthusiasm around the rapidly evolving pursuit of AI and the related data center infrastructure buildout are once again leading the rally[4].

Labor markets are holding up, but perhaps due to employers unnerved by the uncertain fiscal policy environment, they have begun showing signs of moderation. The unemployment rate has remained stable in the low-4% range, but the pace of net new hires has slowed somewhat from last year and initial jobless claims have also been ticking higher. This coincides with consumer sentiment falling off a cliff following the panic around tariffs during April. The University of Michigan Consumer Sentiment Survey is currently at its lowest level in the past 40 years outside of a couple readings in mid-2022 when post-COVID inflation was peaking. As a result, the Federal Reserve has lowered its GDP forecast to only 1.5% for the year, a 0.7% decrease from their forecast at the beginning of this quarter.

Meanwhile, core inflation measured by both CPI and the Federal Reserve’s preferred PCE has continued its multi-year downward trend with the most recent readings at 2.8% and 2.7%, respectively.

These economic readings have left the Fed in quite the quandary. While these are normal levels of inflation compared to historical levels, inflation remains above the Fed’s stated 2% target. However, this spread between actual and target inflation is almost entirely due to stubbornly sticky housing prices. Counterintuitively, while higher interest rates tend to cool economic activity and bring down inflation, mortgage rates mired around 7% have handcuffed many homeowners to their current sub-4% loans, which has dramatically reduced the supply of homes for sale and is actually contributing to housing inflation.

With the economy more or less at full employment as defined by the Fed, these indicators would normally point to an easing of Fed monetary policy. Fed Chairman Jerome Powell said as much at a recent ECB Forum in Portugal, yet he has continued to hold off, citing increased inflation expectations as a result of tariffs in the second half of the year. So it’s a classic Catch-22: lower short-term rates in an attempt to jump-start the stalled housing market and bring the last vestige of post-COVID inflation back to target, but doing so risks overheating other parts of the economy already primed by stocks at all-time highs just as the potential reimplementation of tariffs puts upward pressure on prices. For now, Powell has chosen the status quo despite increasing pressure from White House to push rates lower sooner.

Powell’s wait-and-see approach is probably fitting for investors as well at this moment in time. Just as we started the year with an economy that was fine, but not great; a stock market that was strong, but at high valuations and a little too reliant on a single theme (AI); and pondering the disruptive impact of tariffs and fiscal policy on global trade; that remains the case on all of these fronts at the midpoint of the year.

As we roll forward through time, watching the inherently unknowable future unfold before us, all we can do is focus on the things that are within our control. In terms of financial planning, this means designing well-thought-out financial plans that meet our clients’ individual goals under a wide variety of circumstances. In terms of investment selection, this means opportunistically taking advantage of market dislocations to improve the balance of risk and reward in client portfolios through systematic rebalancing or investment selection. Lastly, and most importantly, this means not deviating from those plans during times when either despair or euphoria – those opposing, yet equally effective destroyers of capital – can cloud our or our clients’ decisions. Knowing the cause of a problem and removing it to improve your outcome is a simple, yet valuable, lesson that the events of this quarter once again reinforced.
---------------------------------------

[1] Sunblock 5000 anyone?

[2] The Antarctic Spring is from September through December.

[3] All references to U.S. stocks, the stock market, or stocks, in general, or their performance are represented by the S&P 500 Index and its total return.

[4] This comes after AI-related stocks shrugged off a temporary downturn starting in February after the Chinese company DeepSeek claimed to have developed an AI model that performed almost as well as U.S.-based models for a tiny fraction of the cost of what leading U.S. companies are spending.

DISCLOSURES

Fees: Gross-of-fees composite returns incorporate the effects of all realized and unrealized gains and losses and the receipt, though not necessarily the direct reinvestment, of all dividends and income.  Gross-of-fees returns are presented before management fees, but after all trading expenses.  From inception through December 31, 2020 and after July 1, 2024, the Beginning Value Method (BVM) method was used to calculate returns. From January 1, 2021 through June 30, 2023, the Average Capital Base (ACB) method is used. Beginning on October 1, 2020, the net-of-fees returns are calculated by deducting model investment management fees, which are defined as the highest, generally applicable fees for the strategy of 1.00% of all composite assets. Prior to that, generally applicable fees were 1.25% for equity assets and 0.50% for cash assets. The firm's current management fee schedule is as follows: 1.25% on assets below $1 million, 1.0% per annum for assets from $1 million to $5 million, 0.85% per annum on assets from $5 million to $10 million, 0.75% per annum for assets from $10 million to $20 million, 0.65% per annum for assets from $20 million to $35 million, 0.55% per annum for assets from $35 million to $50 million, and 0.50% per annum for assets over $50 million. Such fees are negotiable. Where applicable, the total bundled or wrap fee charged to each portfolio is dependent on the end client’s financial advisor and wrap sponsor. The composite includes accounts that do not pay trading fees.

Definition of The Firm: Kovitz Investment Group Partners, LLC (Kovitz) is an investment adviser registered with the Securities Exchange Commission under the Investment Advisers Act of 1940 that provides investment management services to individual and institutional clients. From October 1, 2003 to December 31, 2015, the Firm was defined as Kovitz Investment Group, LLC. Effective January 1, 2016, Kovitz Investment Group, LLC underwent an organizational change and all persons responsible for portfolio management became employees of Kovitz. From January 1, 1997 to September 30, 2003, all persons responsible for portfolio management comprised the Kovitz Group, an independent division of Rothschild Investment Corp (Rothschild).

The description of products, services, and performance results of Kovitz contained herein is not an offering or a solicitation of any kind. Past performance is not an indication of future results. Securities investments are subject to risk and may lose value.