The stock market rally ran into the wall of higher interest rates at the beginning of August. As a result, the market gave up their July gains and posted a -3.3% loss for the quarter. This was the first quarterly decline since the third quarter of 2022. Given the sharp upward turn in rates, the stock decline was actually rather modest; if investors truly believed the Federal Reserve would keep rates around 5.5% for the foreseeable future the decline probably would have been much worse. In other words, interest rates are driving the stock market right now, and not in a good way. The bond market also slipped into negative territory in aggregate last quarter, though many sub-sectors remained positive. As higher interest rates tend to compress earnings multiples, the high-flying NASDAQ gave back more (-3.9%) than the stodgier Dow Jones Industrial Average (-2.1%). That said, NASDAQ remains far ahead year-to-date. Unfortunately for small cap stocks, returns in this area (-5.2%) continued to trail all other domestic indices. Investors continue to favor larger, more profitable, and less leveraged companies.
International stocks also declined last quarter. Most foreign economies did not have the economic bounce in the third quarter that the U.S. did, so they didn’t see earnings estimates rise as much. Developed foreign economies were off -4.1% while emerging markets dropped -2.9%. India was a bright spot for emerging markets. Small company stocks in emerging markets did much better than larger ones; they recorded a surprising 2.9% gain. EM companies that focused on domestic demand did quite a bit better than those that rely on exports.
Bonds had another rough quarter. I’m going go into detail on the bond market in the Commentary section, so I will just say for now that last quarter’s -3.2% return wiped out all the year-to-date gain for the index. Nevertheless, several sectors posted a gain last quarter and are largely sidestepping the ongoing rout at the longer end of the high-grade market. 3-month T-bill yields are approaching 5.5% right now so money market yields are proving a strong alternative to bonds.
In terms of alternatives, gold also declined last quarter (-3.7%; don’t let anybody tell you that gold is an inflation hedge). Since the dollar was strong due to America’s relative economic strength, gold went down in dollar terms. Real estate continues to be hurt by rising interest rates, but oil price gains led commodities higher.
The story of 2023 was supposed to be falling interest rates as the U.S. economy cooled, and strong foreign markets as the cooling U.S. economy dragged down the dollar. This is how the first quarter began, and that is how we positioned portfolios back then. However, by May that scenario had begun to collapse. The U.S. economy did not slow down, the Federal Reserve continued to hike interest rates, and foreign currencies slumped. All one can do is try to be among the first to recognize when the consensus forecast is wrong and update portfolio under- and over-weights accordingly. We believe that we did a very good job of reducing interest rate exposure on the bond side and underweighting income-oriented industries (utilities, real estate, etc.) on the stock side. We didn’t overweight technology as much as we might have because that industry historically suffers when interest rates are high. Just about all of the trades we made in September, and so far in October, have been designed to collect more current income (short term, floating rate bonds) or reduce net exposure to the high return sectors that would be high loss if bond yields keep rising.
If you want to understand the impact of higher interest rates on stocks, here is a thought experiment. Suppose there were three investors, Mr. Optimist, Ms. Practical, and Mr. Pessimist. They all have money in the stock market. Mr. Optimist hopes for 12% per year, Ms. Realist would be happy with 8% or 9%, and Mr. Pessimist says he’d be lucky to get 5%. Every so often Mr. Treasury Bill comes along and makes them an offer of a guaranteed return. The offer is usually around 2%, but sometimes the offer is as low as 1% and other times as high as 3%. Either way, the three investors always turn Mr. Treasury Bill down. In January, however, he offered them 4% guaranteed. Mr. Pessimist was sorely tempted – after all, 2022 was a bad year for stocks. When Mr. Treasury Bill came back in April offering 4.5%, Mr. Pessimist sold his stock and accepted the deal. “Maybe I’m getting a little less that I wanted”, he reasoned, “but I’m getting a guarantee”. He sold his stock. Mr. Treasury Bill came back again in July offering 5%, and now he is offering 5.5%. Ms. Practical is weighing the offer carefully. “You don’t often get the chance to lock in a yield this good”. The “Mr. Pessimists” are out of the market now. If the “Ms. Practical” out there begin selling …
Simply put, interest rates are driving the financial markets. As long as they continue to rise, most stocks are going lower. Seasonally, however, markets tend to bottom out in October and post gains from October’s lows through the end of the year. I feel confident that when interest rates finally peak due to economic weakness and begin to head lower, we could see a surprisingly strong stock rally. I just don’t know how close we are to that “when”.
I included this chart to show how well the biggest seven stocks have performed relative to the rest of the market. In the past when I have pointed out this discrepancy the point was to focus on the high and ultimately unsupportable valuation of that handful of technology-related stocks. Today I would prefer to focus on the other 493 stocks and how inexpensive all but maybe 15-20 of them have become. Additionally, I’d like to focus on how cheap stocks smaller than the top 500 are. Below is a ten-year chart of the U.S. stock market again separating large stocks, all stocks equally, and small stocks. Small stocks posted a 10-year compound return of 5.7345%. All stocks equally-weighted have a ten-year compound return of 7.5363%. There is no sense that the vast majority of stocks need some time to “cool down” after a strong decade of performance. The broad market is trading at February 2021 levels, while small caps have done almost nothing since August of 2018.
There are some very good reasons why smaller companies have under-performed, most having to do with lower profitability and higher interest costs. That said, there is a point in the business cycle where interest rates are falling in response to economic weakness and investors anticipate lower rates will stimulate demand. Early-to-midway through an economic recovery, almost all companies are profitable. In the interval between the anticipation of an economic recovery and the actual economic recovery, small cap stocks often more than double (2003-2006, 2009-2011, late March 2020 to early November 2021). I don’t know when the next cycle will begin, but the potential returns offered by the broader market, and small caps in particular, are very exciting.
Since I have written a lot in this Quarterly Report about how important interest rates are, I’m going to devote the Commentary section to bonds and how they work. At their most basic level bonds are a contract between a borrower and a lender in which the borrower receives a sum of money and the lender receives a promise to repay the money plus an additional amount periodically to compensate them for two risks: 1) the risk that the principal when returned will have less purchasing power due to inflation than it did when the loan was made; and 2) the risk that the borrower is unable to pay back the full amount borrowed. The former is known as inflation or interest rate risk, and the latter is called default or credit risk. Today, let’s focus on interest rate risk.
If I buy a 5-year bond (in other words, make a loan) that yields me 4%, I’m going to receive $40 per year for every $1000 I invest. Let’s say one year later interest rates fall to 3%. Somebody wanting to buy a bond similar to mine at that point would only receive $30 per $1,000. If they saw that I was receiving $40, they might ask to buy my bond. I would sell that bond for more than $1,000 because I can’t get the same interest today as I could one year ago. Let’s say in year two interest rates go to 5%. I feel bad because I’m only getting $40 per year whereas a new issue buyer could get $50. If I go to sell my bond in order to buy the higher yielding bond, the buyer will not give me $1,000 because she would be losing out on $10 of income per year. Simply put, when interest rates go up, bond prices go down and when interest rates go down bond prices go up.
Typically, the longer the time frame until a bond matures the greater inflation risk the buyer takes, so the more interest he expects to receive. Generally, two-year bonds yield less than five-year bonds which yield less in turn than thirty-year bonds, so a graph that represents bond yields over time is typically upward-sloping. That said, there are times when this relationship does not hold true. Today the Federal Reserve is holding short term interest rates unusually high in order to fight inflation. The bond market expects rates to begin to decline next year, so five- and thirty-year bonds yield less than two-year bonds. This is called an inversion. Inversions are usually regarded as signaling distress in the economy.
Under normal circumstances, the distress will play out promptly in the form of a recession, which will squash inflationary pressures and eventually allow the Federal Reserve to start lowering interest rates to stimulate the economy once again. So far in 2023 the distress has not been acute enough to cause a recession (perhaps because all of the monetary stimulus put into the system as a result of Covid shutdowns). In any event, interest rates have soared over the past two years such that bond investors have been crushed (unless they owned bonds have been short enough in duration that they matured before their future value could decline). Remember, if starting yields are low enough (ten-year bonds yielded around 1% at the beginning of 2021) and duration is high enough (7 years or so), bond yields rising from 1% to 5% over three years means you lose 25% (3 years of 1% interest) minus (4% higher yields times duration of 7; 3%-28%=-25%). Ouch.
This is a bigger loss than bond investors experienced at any point in the 1970s, because starting yields in the 1970s were much higher and therefore durations were somewhat lower. In fact, I’ve heard that the only worse period for U.S. bond investors was the late 1780s. Nobody’s retirement income projections planned for a 25% loss in bonds – it had never happened before in the modern financial era. That does not mean that it was unforeseeable. Longer term interest rates on the United States average closer to 4%. If one bought a bond in 2012 or 2016 or 2020 at a yield of less than 2%, one should have been aware of the loss potential if yields “normalized”. Mitigating loss potential would have involved underweighting duration and/or shifting a meaningful portfolio of one’s bond exposure to alternatives. We did both of these.
There are a couple of inferences I hope you will get from this Commentary:
- In bonds, low yields lead to low future returns. When the Fed forced interest rates below 2% after the Great Financial Crisis (2007-09), they created a bond market “bubble” that was going to pop at some point when yields came back to normal levels.
- Bond yields are much higher now. Therefore, future bonds returns will probably be much better than they have been over the past 10-15 years. The math is much better for bonds today even if rates go higher since coupon rates are now high and duration is lower.
- Investors tend to see the recent past very clearly and the distant past very poorly, so they tend to position themselves to fight the last war and not the next one. The Fed tends to respond to investor fears even when they should know better.
It is hard to state how difficult it was to be a bond investor over the past decade, knowing that Federal Reserve policy meant that investors were being systematically underpaid for inflation risk. Today that is not the case. Many if not most sophisticated investors will tell you that bonds are more attractive than stocks today on a risk-adjusted basis, because bond prices fully reflect the new interest rate reality while many (larger) stocks still trade as if borrowing costs are going back to three or four percent. We anticipate shifting towards higher bond weightings in 2024, but we are always going to be nimble enough of thought to change our opinion if conditions warrant.
 Performance information from Standard & Poors, NASDAQ, and Dow Jones through NEPC.
 Foreign market performance information from MSCI International through NEPC.
 Bond performance from Bloomberg through NEPC. Gold performance through NEPC
 Gold is a hedge against currency depreciation. If the dollar is strong, gold is not going to gain in dollar terms.
 MAGMATN is Microsoft, Apple, Google (Alphabet), Meta (Facebook), Amazon, Tesla, and Nvidia.
 It’s not like they were all that strong in the preceding decade (2001 to 2011) either.
 If you want to get deeper into the mathematics of bonds, duration is a formula which calculates the principal gain or loss of a bond given a 1% change in its yield. The inputs are the bond’s coupon payments and the length of time to its maturity. A duration of 3 means that the bond’s price will change 3% for a 1% change in interest rates. The lower the coupon rate of the bonds and the greater the time until maturity (when you receive your principal back), the higher the duration. Higher duration bonds give you more total return than low duration bonds when interest rates fall, but when the rise higher duration bonds lose more.
 The bond market tried in 2013 and 2018 to “slow leak” yields upward to avoid the pop that we eventually began to get in 2021, but the Fed capitulated both times to whining stock investors.
 A 4% gain in yields over three years would produce a 9% loss (3 years times 5% coupon or 15%) minus (4 years times duration of 6 years or 24%). Duration is lower today because higher bond coupon payments mean more money (interest) comes back to the lender sooner.
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