Gnostic Capital Global Large Cap Portfolio Return for the Quarter ended 06/30/22.

For the fiscal quarter ended June 30th, 2022, the Gnostic Model Portfolio ended with a valuation of $594.77 USD per share. As the valuation for the quarter ended March 31 was $661.29 USD per share, the loss for the three months was 10.1%.

All major indexes were broadly lower for the quarter. The Dow Jones Industrial Average fell from 34,718 to 31,061, a decline of 10.5%. The Standard & Poors 500 Composite Index declined from 4,539 to 3,827 for a loss of 15.6% in the quarter. As to the NASDAQ 100 Index, the tech heavy index declined from 14,863 to 11,611 for a loss of 21.9%.

Broadly based losses, given the magnitude, represent a reminder that equity movements, taken as a whole, far more reliably foreshadow global economic output than do economic forecasters.

In fact, as a harbinger, index movements do a better job than do the majority of economists in aggregating the impacts of both interest rate moves, money supply changes, geopolitical shocks to the system and supply/demand imbalances. Over the past 22 years, all major economic slowdowns (for the sake of discussion, let’s call them “recessions”) have been presaged by powerful and rather sudden declines in global stock prices. A typical recession is defined as two periods of GDP contraction, but that calculation gets muddled when federal statisticians play fast and loose with inflation numbers. If GDP increases by, say, 2%, but inflation is determined symbolically, an ex-inflation decline in economic output may have already been taking place for the past six months. I certainly think that to be the case.

In the case of the economic recession declared to have started in March 2001, stock prices fell hard almost a year beforehand; all the while economists waited, and waited, and waited some more, until enough data had been compiled, before declaring a recession to be in effect, one that had largely already ended, before the verdict was read to the court of public opinion.

One issue for data crunchers might be in the difficulty of estimating economic growth or economic reductions in GDP based upon the “wealth effect”, sometimes referred to as “animal spirits”.

Both terms refer to a form of exuberance that arises when paper wealth increases faster than the rate of inflation.

After a time, investors from all walks of life, when in possession of statements of account indicating large and sustained increases in paper wealth; most feel more comfortable parting with some spoils on consumptive or non-investment related purchases. We are all, in varying degrees, impacted by the wealth effect. Those who sell off portions of their equity portfolio at a capital gain above the rate of inflation, or above the rate of GDP growth, for spending in the external economy, add to non investment demand based inflation. Most of us intuitively “get” that; not only don’t we need third party economic crunchers to affirm what we already know, many of us find it surprising that the wealth effect isn’t talked about more, because demand inflation based upon the wealth effect is as powerful an inflationary driver as are supply chain challenges.

The stock market movement in the first half of 2022 is telling us that the spending reduction based upon a contraction of the “wealth effect” is nigh.

For the first half of 2022, the DJIA is now down 14.3% on the year. For the first half of 2022, the S&P 500 is down by 19.6%. For the first half of 2022, the NASDAQ 100 is down by 28.9%. This loss breakdown has meaning for overall spending and consumption within the US economy and the global economy as a whole. I know exactly the sort of investors who prefer Dow Jones equities to S&P equities to NASDAQ equities. If I were to paint a broad canvas; those who primarily own Dow stocks tend to be more conservative; they are less susceptible to the siren song of animal spirits and haven’t spent recklessly during the upcycle. Such investors tend to rely more upon dividend increases on their portfolio for discretionary, non investment related spending. They haven’t been greatly hurt, on a relative basis; with just a 14.3% loss, provided that things get no worse for the balance of the year, this is merely an irritation.

As to those with S&P equity investments, a 19.6% decline for 2022 with the majority of the loss experienced in the quarter just ended, will impact broad swathes of Americana in Q3. Those S&P investors will see the impact in their 401K statements, their personal portfolio statements and the pension plan statements of accounts. There will be discussions around dinner tables about the benefits of cutting back on certain discretionary purchases, framed from a positive standpoint that this is likely to be temporary.

Turning to those with NASDAQ based portfolios; these investors are most greatly inclined to spend during upcycles based upon the wealth effect. A lot of Teslas are purchased for cash with option incentive awards. The 30% index decline, broadly based, within the tech heavy, fintech heavy and human capital intensive knowledge based industries, rest assured it hits upper spending sectors of America super hard. Millions of Americans employed in knowledge based and tech sectors earn a great deal of their income from stock incentive awards, a portion of which are annually converted to cash and used to fund their lifestyle. I refer to them as “NASDAQians” (citizens entirely dependent upon of the health of businesses listed on the NASDAQ for their wages and stock grants); their spending is highly leveraged and completely correlated, not to debt, but rather to the stock market movements.

So, when the market turns against the NASDAQ, the economic pain in the real economy, based upon the contraction in spending from the nouveau riche, is tangible. Some don’t know it yet, but their accountants will be telling them soon enough. NASDAQians can protest all they like to the contrary about their fiscal discipline, but it rings hollow. I know many NASDAQians; I believe that I know how how they think, their expectations for life, I know exactly how they spend, I know precisely where the funding for consumption is provided and it isn’t from cash wages. Most firmly believe that share option packages, stock grants and awards are an entitlement rather than just a fortuitous perk, a corporate allowance if you will, designed to permit the continuation of a lifestyle that supports highly priced discretionary purchases of all manner.

Global supply chain issues will be partially resolved through a reduction of animal spirits.

Certain demand based inflation should abate as corporate share option awards, now underwater, stop getting turned to cash and used to provide funding for expensive purchases. For NASDAQians, I envision the back half of 2022 as a period of digestion on previously made purchases; incremental spending taps have likely been turned off. A 30% decline in the NASDAQ impacts the wealth effect sufficiently to dampen certain inflationary factors, but won’t necessarily lead to deflation; the losses in the stock market aren’t enough to force a disgorgement of large capital purchases into the secondary market. For a broader price correction in the real economy, a larger stock market decline will have to take place over the balance of 2022.

Global manufacturing supply chains will continue to move, inexorably, away from “autocrat oil”, “conflict natural gas”, stolen wheat, pirated sunflower oil and Chinese artificial exacerbation of supply chain issues. And in 12 months, inflation, being a moving target, will more than likely revert back to a more normalized 3%ish figure, after a multiyear increase that has resulted in almost everything we consume, invest in or rely upon for production having gone up by about 40%, which will be fully in line with the increase in global money supply brought about by pandemic spending. Prices won’t fall, they will just stop going up by the current, underreported, degrees and governments will declare that the fight against inflation has been won.

Once input prices have settled at a level consistent with the absolute M2 supply increase since 2019, inflation will normalize. We are already closer to that point than most think and in some commodity cases, there has been an overshoot.

In a recession caused by the end of the wealth effect, inflation and war, what is an investor to do?

For the first half of 2022, the Gnostic Large Cap portfolio is down by 10%. That isn’t enough to be wholly disheartened; the relatively limited total decline suggests that something is working out well enough to keep at it. Investments that held up respectably in Q2 were generally health care based, such as Pfizer (even on the quarter), Novo Nordisk (up 1% on the quarter), Unitedhealth Group (down 1% on the quarter) and Cigna (up 7% on the quarter). All in all, roughly 40% of the portfolio was even, or up, on the quarter and this, plus received dividends, was enough to restrain the overall loss from non-consumer staple investments or financial related investments to something just uncomfortable and endurable rather than intolerable. My natural state, as most of you have divined from historic reading of my views, is relative discomfort; when I am comfortable, one should be more alarmed than not. So, for now, there is little to be done in my accounts other than observe a natural portfolio rebalancing of weightings, for the latter half of the year, via price actions rather than sell decisions. That, and live within one’s means and invest within one’s means.

Now is not the time to attempt to call market bottoms. Broadly based indexes will tell us where the stock market floor lies and when that turn for the better is coming, far more dependably than do investment pundits. The market is presently telegraphing spending pattern changes in upper end products; higher end discretionary items are a margin sweet spot in corporations that have been, as yet, largely unaffected in the current economic overviews that talk up avoidance of a soft landing. In a recession, all equity investments get hit, eventually.

In the coming weeks, GlaxoSmithKline (GSK-NYSE, $43.75) will be added to the account prior to the separation of the pharmaceutical business from the consumer health products company.

I do not expect an immediate payoff; arbitragers have the math worked out quite well and I believe that the spin-off of Haleon will not initially be a “sum of parts” win. Rather, it is my belief that Haleon will deleverage after providing GSK with a multibillion cash payment, will bulk up via acquisitions in its own right over time while simultaneously rolling out current brand extensions. Margins at both GSK and Haleon are fine.

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