Quarterly Market Perspective for 3Q22
As hard as it would have been to believe, three months ago, that the stock and bond market could both continue to decline, they both did. U.S. stocks gave up an additional -4.88% while bonds moved -4.75% lower. Through the first three quarters of 2022, stocks are off -23.87% and bonds stand at -14.61%[i]. A 60/40 mix of stocks and bonds, long considered the benchmark for diversified portfolios, would have lost -20.17%. There are only two years, since records have been kept, that a blended stock and bond portfolio has lost -20% or more; 1931 (the heart of the Great Depression) and 1974 (Arab oil embargo). This kind of year only comes around every 40-45 years or so. If it is any consolation, both 1931 and 1974 were followed by two consecutive years of 15%+ returns.
Figure 1: 60/40 Portfolio Returns 1926-2022
Small cap stocks peaked on November 8, 2021 and through September 30th, 2022 had declined a little over -32%[ii]. Compare this to the S&P 500, which didn’t peak until this past January 4th and is only down -25.23%. Small caps only shed -2.19% last quarter, so it’s possible that they are bottoming earlier and will lead the next bull market; they certainly lagged during the last one (especially after September 2018). Energy has been the only stock sector of refuge this year, gaining over 40% and even that sector suffered a -24.5% plunge between June 8th and September 26th. 2022 has seen nice but short rallies followed by relentless grinding declines to lower lows in almost every sector, including those that traditionally hold up during periods of stock market weakness (utilities and real estate) or inflation (gold/precious metals).
International stocks lost another -9.36% last quarter, leaving them off -27.09% year-to-date[iii]. Latin America, which is heavy in natural resources-related companies, rose last quarter and is modestly ahead over the first nine months of the year. Japan is down close to -27% this year but that is mostly due to a plunge in the yen versus the dollar; in yen terms the Nikkei is close to flat on the year. Elsewhere, however, things are just not good. Asia (aside from Japan and India) is suffering from the continued contraction of the Chinese economy and Europe is being clobbered by Russia’s Ukraine war and its own mismanagement (looking at you, England).
Rising bonds yields have served as the main catalyst for this year’s poor market performance. Bonds continue to suffer from several headwinds:
- inflation continues to surprise on the upside. Goods prices are moderating, but wages and housing costs are still rising greater than 5%.
- world central banks are selling dollar-based securities (bonds) to limit the rise in the dollar against their currency. Remember, the price of a bond moves inversely to the yield on that bond.
- the U.S. Federal Reserve is selling bonds to banks to take money out of circulation, thereby cooling economic activity (and hopefully inflation as well).
On the plus side, yields on the benchmark 10-year Treasury Bond are now over 4%, so savers are finally beginning to get rewarded. The fact that bonds now yield more than twice as much as stocks provides a good rationale for believing that bonds will be attractive once the Fed stops raising rates. We are already seeing institutions selling stocks to buy bonds because they can lock in actuarily acceptable returns. While 2022 has seen the worst high quality bond sell-off in over forty years, it seems very likely that the worst is now over.
We have been very active this year because markets have been very difficult. In many model portfolios, we have hedged the dollar exposure in international bonds and in part of our international stock portfolios. We also have added commodity exposure, bond alternatives and interval funds in some portfolios. We now have very little exposure to the most volatile area of the stock market, small cap growth funds. The goal has been to get defensive, but not so defensive we wouldn’t participate if there was a meaningful rally in risk assets.
Figure 2: Stock and Bond Returns. Very rare to see both stocks AND bonds doing so badly at the same time. In down years, bonds almost always act as “ballast” to cushion the blow from falling stock prices.
At this point, it seems fairly certain that 2022 is going to be a “red marble” year[iv]. The hope around mid-year was that inflation would show signs of moderating in the third quarter of 2022 such that the Federal Reserve could be done tightening by year-end. Anticipating this, investors would begin to buy stocks. In fact, this did happen between late June and mid-August. Unfortunately, the July Consumer Price Index report, released in mid-August, was just too strong. It forced Fed Chairman Powell to make a very hawkish speech the next week at the annual Fed conference in Jackson Hole, Wyoming, which crushed the 2022 hopes of both bond and stock investors. He said the Fed is not going to stop raising interest rates in 2022, and furthermore they do not expect to begin to lower them any time in 2023. This was not what investors wanted to hear.
This creates a dilemma. U.S. stocks are not expensive now if one believes that the economic downturn the Fed is engineering in order to bring down inflation is not going to be either deep or long-lasting. In fact, if corporate earnings decline modestly into 2023 as margins contract but begin to rebound in the second half of next year, the market may rally. It should be noted that there are two key “ifs” in the last two sentences, and we aren’t even considering Russia, China, and potential inclement weather affecting consumption, so there are no guarantees. That said, we finally have hit price levels on many companies for which a patient investor today is likely to make a nice return by 2025 or 2026. Investors just have to have the fortitude to hold on, because the next few months are likely to contain more negative surprises than positive ones.
The good news is that big declines are often followed by big gains (though this should not be taken as a guarantee):
Commentary – Beware the V
We receive a tremendous amount of research every day concerning the economy, the stock and bond markets, interest rates, real estate, global geopolitical developments, trading strategies, and more. Sometimes I receive something so useful I immediately think, “that’s going in the Commentary”. Such was the case with this chart I was recently sent by Goldman Sachs. It shows the average performance of the S&P 500 stock index during a bear market. As you can see, the decline begins with a long meander, such that one doesn’t even think about it as a bear market. Some market sectors are performing well, while others have rolled over.
Almost every market pundit refers to this first -5% down move as being a “correction”, the implication of which is that it’s nothing more than a chance for over-exuberant areas of the market to cool down a bit before the next upward phase. This represents about 75% of the downturn time-wise. The final -25% is the breakdown and then the capitulation. The breakdown sees accelerated losses compared to the previous phase. The capitulation, where the losses seem relentless and every day investors berate themselves for not selling yesterday or better yet last week, usually doesn’t last very long – it just feels that way.
These declines typically end in what we professionals call a “V-bottom”. When selling goes on for several days in a row and has changed from rational and orderly to panicky and indiscriminate, stocks with strong outlooks are sold alongside those with poor prospects. Sophisticated investors wait for just such an opportunity and when it comes they buy in loudly, hoping others will follow behind them. Warren Buffett of Berkshire Hathaway and Jamie Dimon of JPMorgan are known for having gone on CNBC at the height of especially difficult periods and announced they were buying, leading to sharp reversals. As the chart shows, the opportunity to buy right at the lows is all but impossible. Once investors realize that the “cavalry” has arrived, the stock market can be 10-15% off its lows in a very short time. V-bottoms occurred on February 11, 2016, February 8, 2018, December 26, 2018, and March 24, 2020. If you sold at or near the height of the panic, you could not recover – there was no opportunity in subsequent days, weeks, or months to buy back in anywhere near the lows. In the world of professional money managers, doing so is referred to as “permanently impairing capital” because the sale, and lack of market recovery participation, locks in the loss for all future time periods.
These V-bottoms are the bane of professional money managers. We don’t want to participate in the highly volatile late stage of a market breakdown, but we know that time is on our side – markets tend to rise over time because corporate profits in the aggregate tend to rise over time. For example, in the year ending December 31, 1971 S&P 500 earnings were $41.16 per share; fifty years later they were $210.65 – more than 5 times higher[v]. Selling always carries some risk because it involves fighting against the current of rising earnings. Thus, the worst case scenario is to sell at the nadir of a V-bottom. There are two strategies to avoid making this catastrophic mistake. One is to never sell. You just ride out the difficult market periods with the knowledge that capitalism tends to funnel assets ultimately towards productive capacity and there is no reason to expect it won’t this time either. The other is to reduce positions gradually. The logic is that if portfolios are made less risky in increments, some of the sales will have taken place well before the ultimate bottom, such that one can buy back in before stock prices return to the level at which those sales were made. The strategy has the advantage of losing less into the worst part of downturn, but it also carries the risk that by the time one realizes that the market has truly bottomed, re-purchases will occur at higher levels.
Statistically, one should expect short term downturns not to turn into major bear markets, because they usually don’t. Therefore, also statistically, one should not be a net seller when stocks go down. Yet there are exceptions to the rule. In NBA basketball, statistically, one should only shoot 3-point shots because the expected value of a three-point shot (3 points times 37% likelihood of success equals 1.11 points per possession) exceeds that of a two-point shot (2 points times 45% likelihood of success equals 0.90 points per possession). The exception is the lay-up, of course. Lay-ups are made 58% of the time, so the expected points per possession is 1.16 – better than that of a 3-point shot[vi] . Markets are of course difficult to predict. The odds of stocks rising on a given day is 54% – only slightly better than a coin flip. Yet every so often prices get so out-of-whack with fundamentals that at least some type of decline seems like a lay-up.
The trick, as always, is to know when you are in one of these periods. Last year I believed that stocks and bonds had become considerably overvalued, so I started shifting some of our models into investment we believed would be more stable in a downturn. While the most egregiously overpriced consumer technology start-ups (Zoom, Peloton, Draftkings) did in fact decline -40% or more in 2021, the biggest blue chips like Apple, Microsoft, and Tesla still soared over 30% each. Lay-up missed. This year we are benefitting from alternative funds and from the underweight to big growth stocks, so in a sense we are one for two. If stocks continue to struggle for a while, our strategy may prove to be helpful (as it will have both reduced volatility and generated higher returns). If the market makes a sharp V-Bottom leading to a lasting recovery, then our action will probably not have been accretive to value.
Hopefully this commentary has demonstrated the difficulty of navigating market declines. It is easy to say that one saw a decline coming but much harder to time when to get in and when to get out. Because of this, we have adopted a gradualist strategy of frequent minor adjustments to risk level as opposed to an “in-or-out” kind of strategy. We know that we will be wrong from time-to-time, but we try to keep the consequences of this small. On the other hand, poorly timing an “all-or-nothing” strategy would be a disaster if the market traces out a V-bottom pattern (as it tends to do if the Federal Reserve makes a strong pivot).
One should not be a stock investor if one does not understand that the markets will give even diversified investors a -20% loss from time to time (especially in those rare situations where bonds do not mitigate volatility but in fact make them worse). On the other hand, bear markets losses of 40% or more have historically been avoidable by shifting a portion of the portfolio into cash, cash equivalents, or other non-correlated assets. The less a portfolio declines, the quicker it can recover in the next bull market.
We are doing our best to navigate this environment. We welcome any questions or comments you might have about your portfolio.
[i] Per Morningstar Workstation
[i] Point-to-point performance information here and elsewhere from Y Charts. Russell 2000 Index used as the proxy for small cap stocks.
[iii] Per Morningstar Workstation
[iv] The marble concept was introduced in our 2nd Quarter 2022 Commentary to note a year of significant stock losses. This differentiates it from a pink marble (minor loss), grey marble (minor gain) or black marble (major gain) year.
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