2022Q3 - Quarterly Review & Market Commentary
13min video
After a strong rally early in the 3rd quarter, most gains were given back as stocks slid and yields surged after hawkish actions from the central bank. Let’s talk about the third quarter, our positioning, and our expectations going forward.
Video Transcript:
After a strong rally early in the 3rd quarter, most gains were given back as stocks slid and yields surged after hawkish actions from the central bank. Let’s talk about the third quarter, our positioning, and our expectations going forward.
First off – this is a longer video than usual – so if you prefer to read rather than listen to my voice for 10mins straight, which my wife can attest to being 9mins too long, I have the full transcript over on my blog.
All right - So far this year, there haven’t been many places to hide, with most asset classes participating in the market pullback. As you can see on this chart, most are revisiting their year-to-date lows.
So, what’s causing this to happen?
Early in the quarter, we saw a substantial bear-market rally derailed by more inflation worries. The Federal Reserve’s head Jerome Powell raised rate expectations for the remainder of this year and revised growth and unemployment forecasts. The Bank of England also hiked. The misalignment of fiscal and monetary policy is creating issues here in the US and overseas. This is because a fiscal splurge, such as canceling student loan debt here in the US or subsidizing energy prices in the UK, are inflationary actions and may lead to even more hikes and poses risks of further rises in long-term yields currency issues such as the pound depreciating and the dollar appreciating. Japan also intervened for the first time since 1998 to prop up the yen. This creates a problem because it causes yields to rise. And as yields rise, stock prices fall. Because the rate used in valuation formulas to discount those future expectations is higher, resulting in a lower present value price today.
So how much more will rates and yields rise? Well, on this chart, we can see where the Fed Fund’s rate target now sits by the end of the year, specifically as it compares to pass quantitative tightening cycles. A rapid pace that we’ve already set out on. Now, as you can imagine, there are a host of differing opinions on this. Speculation and sharing my opinion on it doesn’t serve any purpose if they are doing too little or too much. Instead, we should focus on things that we can control.
Market backdrop
So let’s talk about the Market Backdrop in the future and what we can control because of it. Remember, the Fed has two mandates, prices, and employment. So we’re watching the inflation data in the U.S. and the euro area, including the Fed’s preferred PCE metric. For now, the Fed seems to care about evidence that inflation is decisively on a path toward its 2% target.
So #1 – the Fed Rate Hikes aren’t done, as markets are pricing two more hikes in the 4th quarter.
#2 – Inflation remains much too high
#3 – Recession warning signs are growing
#4 – The number of companies issuing negative earnings guidance is rising
#5 – The currency and bond market volatility has gone through the roof.
#6 – The Russia/Ukraine crisis continues
All 6 of these things mean that our top priority for the 4th quarter is to stay focused on our longer-term goals and avoid the impulse to “get out” of the market and abandon our long-term strategy. That said, I realize this isn’t an easy task by any means; remember that sound financial plans can overcome periods of intense volatility, but only as long as we stick to the program.
Headline Fun
Because of this, you will see headlines like, “unemployment starts to rise, home prices plummet, wage growth stagnates, corporations freeze hiring, and my favorite, Famous Investor Who Called The 2008 Crash Issues Warning”. Remember, fear-mongering gets clicks and sells ads. Please expect these headlines to be present every time you turn on the news. But still, what affects the economy differs from what affects the stock market. Economic Data looks in the review mirror, meaning it is a lagging indicator.
In contrast, the stock market always looks out the front windshield, where it takes a story about tomorrow, how many chipotle burritos we think we will sell, and assigns a price today. So, let’s assume that the fed’s aggressive rate hikes have already worked; who’s to say the worse isn’t behind us, even though the real economy takes time for it to trickle through? I’m not saying that’s true, but the question becomes, is the fed going to slam on the brakes so hard that we go through that windshield? To beat the car analogy to death here.
Our Positioning
So, how are we positioned to combat those possibilities potentially becoming realities in the next year?
This year is one of the highest, with 1% or more significant daily swings. This volatility is due to the market attempting to price in future expectations. So when we see these big daily swings, there is an extensive range of what could happen, both good and bad. So when I hear volatility, I hear opportunity. Rebalancing, placing tax trades, and owning the right things in the proper accounts are all ways to take advantage of this volatility.
So, specifically, this heightened macro volatility creates stark trade-offs for central banks at risk of overtightening into recessions. So, our strategic positioning is shaped by our view that central banks will stop hiking next year and not go as far as necessary to get inflation back to target quickly. Recent events reinforce our conviction that they will halt rate hikes and live with inflation once confronted with economic damage – either in the form of recession or cracks in financial stability, or both. This will be more favorable to equity than bonds – so we’re overweight DM stocks. We prefer the public to private equity. Inflation will persist, so we prefer inflation-linked bonds to nominal bonds.
Comfort in Data
Now that we’ve got the doom and gloom part of the video let’s talk about perspective. Many clients I’ve spoken with have relayed that this time feels different. Bear markets and recessions have happened before, each being different for another reason. So let’s look at some data around this.
This chart reflects the bear market sentiment poll from AAII and the average 6/mos gain when the poll sits at certain levels. Last week the level eclipsed 60%, for only the 5th time in history. So people are super bearish, but history says the more pessimistic the investor class becomes, the better the prospective returns look 6/mos out. So here’s where the paradox of investing exists. If I told you that compared to last year at this time, when people couldn’t have been happier with the market and everyone was bullish, one year later, you would be able to invest in stocks at a quarter less relative to their earnings multiple, and 1year treasury bonds would be paying over 4%, there would’ve been lines of buyers like a black Friday sale. So why doesn’t it feel like that now? Well, for everyone, this universal paradox, not just professionals. It’s always going to feel the best at the worst possible time and worst at best possible time to invest. Or has Morgan Housel stated, “Investing: every past crash viewed as an opportunity, (like looking back at 2020 and realizing it was a great buying opp) and every future crash viewed as a risk.”
For those of you who missed out on 2020, you said I’ll buy the next pullback. Well, it is presenting itself now – but I realize those emotions are still there. Real wealth is created during times like this.
Average Recession
There’s so much talk of recession, and If we are in one, this wouldn’t be the first time, so luckily, we have some data to work off of. Ben Carlson put together this chart reflecting the last 12 recessions. The average stock market drawdown during a recession from WW2 is about 31%. So that’s the average, and it could be worse, of course, but it could also be better. More important, though, is what happens after. So let’s assume we are either on the cusp of a recession or already are in one, so first of all, we are already down almost 25% on the S&P, so we aren’t starting from zero. This is important; We’ve done much work this year pricing in risk. So coming out of recession, and this is where I want you to pay extra attention, what do the 1yr, 3yr, 5yr, and 10yr numbers look like?
The 1yr is 21% return, which for any other average 1yr does not look as good. So coming out of recession is like being a coiled spring. The 3yr number is 48%, the 5yr number is a double up about 94%, and 10yrs after a recession, on average, you are up 256% or over 3.5x your money.
So everyone wants to know - what will be the story that turns the market around? Well, these things tend to work because the market tends to turn around before the story does. And we want to make sure you are positioned to participate.
So the reality is, again, we aren’t at all-time highs. The stock market is doing its job pricing in all of the headwinds and a litany of negatives ahead of us. It’s much easier to make a video necessitating all of the negative sentiment you are already pounded with daily when you turn on the news. The truth is, to survive as an investor, you have to be able to do both. You have to say, yes, there are risks, and we want to build a portfolio that acknowledges those risks, BUT there has to be some benefit to why people are willing to take those risks, and that’s harder to do than just listing all of the bad stuff. I’ve learned an essential trick to managing perspective and therefore managing money. To develop foresight, you need to practice hindsight. There are no perfectly reliable indicators, but buying fear generally pays off in the long run.
So, to the same point – hopefully, one more hopefully comforting chart for you. If you go back to 1996 and look at when less than 10% of Nasdaq stocks were above their 200-day moving average on this chart from Michael Batnick, which is where we are now, there was never a negative return one year later. NEVER! The average return one year later was 35%! Not a guarantee by any means, but I find data like this a way to be comforting.
One final point is that if you invested five years ago in the S&P 500, many of you watching have been investors since that time, those dollars you would’ve put into the market during September of 2017 would be over 58% higher! Averaging almost 9.5% a year of growth.
Another positive takeaway is that Expected returns for bonds are finally higher than they’ve been in over a decade. TINA is a popular acronym this decade, or there is no alternative. Means, cash, and bonds were paying so little that many investors had to take equity risk. So for those with money on the sidelines, you now have something worthwhile. The one-year treasury is now paying over 4% for crying out loud.
So what should you do now? In short, control the things you can handle. You can manage your savings if you are younger, it's counter-intuitive, but we want the market to be lower for longer, enabling you to save more at these lower levels. You can control how much toxic news you take in and how you are allocated. Focusing on these things and not on the stuff out of your control is half the battle from a mental health standpoint to survive an environment like this and ensure you come out the other side.
Recessions are temporary, but your financial decisions during recessions have permanent consequences. Most, if not all, of the future value of your portfolio and your mental health, comes from the actions you take during falling markets, not rising ones. Avoid big fear-based money decisions right now. I can’t tell you precisely what to do because everyone’s situation is unique. But I can tell you this: don’t make any knee-jerk reactions and jump off the boat in the middle of a stormy ocean. Storms do pass.
I understand that many of you will be looking at another negative quarter on your performance reports. Please, please know that I’m watching things, and I’m here if you want to talk.
As always, we will stay on point, stay the course and stick to our plan.
Take care.
