First of all, we are happy to report that the fourth quarter of 2022 was a positive one for both stocks and bonds. This allowed the year to finish well above the September lows. The S&P 500 closed with a 7.56% quarterly gain, reducing its full year loss to -18.11%.[i] Value industries such as energy and materials gained 22.86% and 15.05% respectively, while growth industries like technology rose just 5.14% and consumer discretionary lost -9.09%[ii].
Maybe the biggest surprise last quarter was the strength in foreign stock markets. Left for dead due to the Ukraine conflict, fears about energy prices in the coming winter in Europe, Covid lockdowns in China, and other concerns, international stocks blasted upward by 17.34%[iii]. There is a lesson here in terms of how profitable it can be to invest in an area when one’s fellow investors have all but written it off. Europe has had a very mild winter so far, such that its aggregate energy usage is much less than forecast, enough so that analysts are moving away from their earlier forecasts of a deep recession. China has recently lifted all Covid-related mobility restrictions, which has produced a bit of a boom in consumer- and raw material-related stocks.
Bonds also gained during the quarter. True, their gain of 1.87% made just a minor dent in the -15% plus losses sustained in the bear market from November 30, 2021 to October 24, 2022, but it looks increasingly like a major bottom was made on that day. After a decade of receiving yields so tiny that they didn’t nearly compensate for taxes and inflation (low as it was at that time), bond investors can now obtain yields of over four percent on government bonds and six percent or more on many high quality corporates. The dollar’s decline during the quarter finally revived international bonds, which had struggled mightily over the past three years. They rose 2.58%, according to Morningstar, after falling more than 14% over the previous three quarters.
Alternative assets had a mixed quarter. Gold rose 9.45% on investors’ belief that central banks would have to ease up on interest rate hikes as inflation itself was peaking. On the other hand, energy prices turned lower which in turn dragged down the returns of managed futures funds by an average of 3.43%. Real estate-related interval funds, which had completely sidestepped the nearly 30% correction in publicly-traded real estate companies in the first nine months of the year, belatedly began to reflect negative effects of rising rates.
After bottoming out in terms of international exposure in the third quarter of 2022, we began to add back to it last quarter as the U.S. dollar made a significant top in October. The dollar is the key to the performance of “risk assets” outside of the United States – as cheap as foreign assets had become, the dollar needed to stop rising in order for those assets to move up. Like a beach ball held underwater, once the dollar trend finally turned lower, foreign asset prices shot upward. Outside of tax-related balancing of gains and losses, most of the changes made during the quarter were either driven by the reversal in the dollar or the desire to by less “tech-heavy” in our growth funds..
By October, bond yields had risen to levels that we had not seen in years, so we also did some “bottom-fishing” in the long-term end of the bond market. As inflation slows, yields come down and allow longer term bonds to make a nice profit. It is always hard to buy securities when they are down 25%-30% year-to-date (as they were back then), but I’m already wishing I had purchased larger positions.
As this is being written, the primary driver in the markets is the deceleration in inflation. This has led to speculation about when the Federal Reserve will stop raising rates (and in fact when they might pivot to cutting them again). This is inherently a bullish conversation[iv], standing in direct opposition to the one we were having a few months ago which was essentially “how high does the Federal Reserve need to get interest rates in order to break the upward trend in inflation”? The falling inflation narrative will be constructive to stock and bond prices as long as it lasts. That said, we are heading into corporate earnings reporting season in a couple of days. This is not likely to change the positive short-term dynamics in the bond market, but it certainly could for stocks if companies start warning about lower sales and higher costs. Let’s hope that doesn’t happen.
Commentary – “Di-Worse-ification”
The second half of the 20th century was the heyday of investment theory. Before this time investors tended to be either speculators or income collectors. They did not look at their holdings as a “portfolio”, so they did not think about how much or how little each security correlated to the others. As a result, the values tended to rise and fall in tandem (at different rates, of course). The thought that one might achieve better results by combining securities with different attributes such that they did not all rise or fall at the same time just did not occur to most investors. Then William Sharpe, Jack Treynor, Harry Markowitz, Robert Merton, Fischer Black, and others came along and turned portfolio management into a science. No longer would portfolio managers get away with buying a few promising stocks and/or bonds and hoping for the best; now there were multiple tools to assess risk-adjusted return (and advanced knowledge of mathematics would be required). These Nobel laureates taught us that markets were more or less efficient, and for a little while it actually seemed like they were.
The “Dot.com Crash” in 2000 was the first in several blows the brave new world of investment theory has suffered this century. Clearly markets couldn’t be efficient if Cisco Systems could trade above $150 in March 2000 and under $40 less than eighteen months later. Diversification, the idea that risk-adjusted returns could be improved by putting a lot of different “eggs” into one’s investment “basket” (versus loading up on the type of egg judged to be the best), similarly looked to have been disproved lately as U.S. stocks outperformed during both good and bad times over the past decade. Noting this, a clever pundit coined the term “De-worse-ification”.
A review of asset class performance over the past twenty-five years, however, shows that performance for any particular asset tends to go through multi-year periods of better and worse returns. During that period large company U.S. stock performance were first or second of the ten major asset categories every year from 1995 through 1998, then they didn’t crack the top five of ten in ANY of the next twelve years. Large U.S. stocks jump back into the top five (second) in 2013 and remain in the top five every single one of the next nine years (2013-21) before breaking the streak last year. Similarly, foreign developed and emerging markets each land in the top four every year between 2003 and 2007, but thereafter are only found in the top four together once (2017).
The lesson here is to think about diversification not as something that adds value during a particular market decline but over one’s investment lifetime. An asset class can be out of favor and underperform for the better part of a decade. In fact, some diversification models include gold and oil as additional asset classes to those referenced above. Gold and oil can and have remained out of favor for very long periods of time (close to twenty years), but when they “pop”, they can provide very exciting returns – as oil did last year.
What diversification does do, reliably, is compress the range of potential returns. It takes the highest possible return (100% of one’s in the best asset) out of the equation, but it also removes the worst. Mathematically, it averages out better than the midpoint between the best and worst asset classes, so it is what we call “risk-efficient”. That is why despite it not working well from time to time, diversification remains a foundational principal of investment management.
A little more background might be helpful. The period from 2017 though 2021 was exceptionally frustrating as an investment manager. Large cap U.S. stock had fallen out of favor in the decade of the “oughts”. By 2012, they were priced very reasonably provided the economy did not lapse back into recession. It didn’t, and 2013 through 2016 provided very nice returns for investors (especially in technology). By 2017, U.S. stocks were no longer cheap, and yet they added another 22% that year. In 2018 interest rates began to rise as they typically do late in an economic expansion. Every single asset class suffered in 2018 relative to 2017. That said, large cap U.S. stocks remained a top asset class even with a slight loss; all other equity classes posted double-digit losses. Then they rose another 31% in 2019.
When Covid hit in early 2020 and markets sold off worldwide, it looked like we were finally going to see the kind of correction that would bring large company stock returns back into line with other asset classes, allowing investment returns to be more evenly distributed. In fact, just the opposite happened. Technology’s leadership over the rest of the market only intensified post-Covid, and the performance advantage of U.S. stocks over their foreign counterparts went from large to unprecedented. The extreme out-performance of a handful of American technology companies distorted everything. Any investment professional with a cursory knowledge of history and mathematics knew this couldn’t last, but when and how would it stop?
Finally, last year, the “tech fever” fully broke. The end was foreshadowed in 2021 when the most speculative, loss-making companies began declining in earnest, but it took an inflation spike, a regional war, an oil spike, and 400 basis points of Federal Reserve tightening to finally burst the bubble. Every one of those high-flyers is now more than 25% off its all-time high while energy, consumer staples, and industrial stocks tend to be less than 5% from their highs. Even international stocks are only 15-20% off their all-time highs. Diversification seems to be working once again. Investment theory, as taught by the CFA Institute and the College of Financial Planning, is actually describing the real world again.
I am very excited about the opportunities I have as an investment manager today because all asset prices are much more reasonable. Unlike the entire decade of the 2010s I can get fair compensation relative to inflation for holding a bond. With tech fever having ended, I am not being pushed to over-weight portfolios to an industry sector that I know cannot fulfill the unrealistic growth and profit expectations the market has attached to it. There are many attractively priced stocks outside the United States that are finally starting to attract interest.
At Trademark Financial Management we run diversified portfolios. Not because they are guaranteed to produce better returns (they aren’t) but because diversification provides better risk-adjusted returns in an environment where one does not know what the future will bring in terms of asset class performance. We look for trends, and we monitor changes in the narratives that drive stocks and bond prices at any given time. We will overweight, modestly, those parts of the market that have relative strength compared to other areas, those parts of the market that are more reasonably priced than other areas, and those that fit the narrative currently driving market movements. On the other hand, we will underweight (again modestly) those areas that are either expensive or being de-emphasized by the current narrative. Over the long term, that should lead to above average performance.
[i] Standard and Poors 500 Index, per Morningstar Workstation
[i] S&P Dow Jones Indices, per S&P Global, December 30, 2022.
[iii] MSCI EAFE, per Morningstar Workstation
[iv] Because you are essentially asking, “Are stock prices going to go up sooner or later”? The previous question was essentially, ”For how long does the stock market need to decline”?
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