There’s no set recipe for what’s baked into the investment cake

Tom Bradley: There’s no set recipe for what’s baked into the investment cake

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These are challenging times for investors. Interest rates are up, housing prices are down, inflation is on the march and there’s lots of talk about a recession. Your advisor’s response to this? “It’s all baked into the cake.”

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Well, I’m a baker and know that what goes into a cake, and how much, is critical. I can be reasonably certain of the outcome by following the recipe and measuring carefully. But baking in the investment context is very different.

Before I go there, let’s define what your advisor means. “Baked into the cake” refers to the fact that investors in aggregate (the market) are aware of the gloomy outlook and have already factored it into stock prices. For example, Air Canada is down 30 percent from a year ago in anticipation of fuel-cost pressures and labor shortages. Amazon.com Inc. is down 20 percent because investors now assume bricks and mortar stores are here to stay, and the company will have to fight harder for market share.

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We never know for sure what’s being anticipated, but there are tell-tale signs. If an issue or event is the lead story on the evening news or is dominating your newsfeed, you can be assured that stock prices already reflect it. If a stock goes up after the company reports poor earnings, it’s a good indication that investors were expecting bad news.

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To be clear, when something is said to be baked in, it doesn’t mean stocks won’t react if the negative scenario plays out. The market weighs the odds of something happening but doesn’t usually go all in. It considers all possible outcomes.

There are times, however, when the market is more certain than it should be. It assumes that everything will work out great, or conversely, there’s no way out of the mess. When too much is baked into the cake, there are usually wonderful opportunities for those who are willing to look in the other direction.

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But let’s put the extremes aside and assume the market is all wise and forward looking. We need to fine tune our definition of risk. The stuff we’re reading about today is not what will take portfolios lower in the coming months, it’s the events and forces that are considered improbable or aren’t being talked about. Let’s look at some scenarios that aren’t being baked in.

We know investors are adjusting to inflation and a slower economy. These issues are in the headlines and every investment commentary. It would appear, however, they aren’t factoring in an extended period of high single-digit inflation. At least, the wise old bond market isn’t. Yields are still well below current inflation which means something has to give. Negative real interest rates of four to five per cent (adjusting for inflation) are unsustainable.

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Neither are investors looking for consumer spending to collapse. They’re relying on the fact that the US consumer is in good financial shape and employment is strong.

Indeed, the tight labor market has been a shining light among all the negatives, although this too may be changing with increasing job cuts in the technology sector. Certainly, a serious deterioration of the job market is not yet factored into many economic forecasts.

Something else that isn’t fully baked in is stagflation. This economic term goes back to the 1970s and refers to periods when there’s slow (or no) growth and high inflation. This dreary combination is being talked about, but the assumption is still that a slowdown will take the pressure off supply chains and lessen demand for commodities.

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The discussion wouldn’t be complete without considering the positives. At times like this, important factors that can take your portfolio higher are often obscured by the front-page risks. They get dropped from the analysis and are no longer baked in.

For instance, while we obsess about recession here, the world economy continues to grow, partially fueled by an expanding middle class in India and China. Innovators keep doing amazing things and have plenty of open field ahead of them in healthcare, infrastructure and alternative energy. The adoption of established technologies is changing how businesses and governments are run.

And while it’s unlikely we’ll have peace in the Ukraine any time soon, any accommodation that normalizes the flow of energy and agricultural commodities would be a pleasant surprise for the market.

There’s no set recipe for what’s baked into the investment cake. We never know for sure if an ingredient has been partially, fully, or more-than-fully added. We just have to keep asking the question.

Tom Bradley is chair and co-founder of Steadyhand Investment Funds, a company that offers individual investors low-fee investment funds and clear-cut advice. He can be reached at [email protected].

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